Another financial issue to be aware of now that the U.S. has a brand new tax law: Which account is best for you? A Roth IRA, Roth 401 (k), or a traditional IRA/traditional 401 (k) account? There is no one right answer to every tax issue. The answer is more in the “it depends” category.
This is because there are many rules and nuances that might apply to either type of account. One prime consideration is the new marginal taxes rates which will be in effect starting in 2018.
Let’s start by examining the differences between IRA and 401(k) accounts.
You can reduce your current taxable income with a traditional IRA, 401(k), or other account. Your investment earnings are not subject to tax, but you don’t pay any taxes on them. When you withdraw funds from your savings in retirement, it is considered taxable income.
It’s the opposite with a Roth IRA/401(k) account: While you don’t get a deduction for the amount you contributed, you won’t be subject to income tax on the money you take out after you retire. Your investment earnings, like a traditional IRA and 401(k), are not subject to tax while your money grows.
You won’t pay any taxes on your investment earnings, unlike a traditional IRA, 401(k), or other accounts, if your Roth IRA/401(k account has been open for at least five consecutive years. After reaching 59-1/2, your investment earnings can be withdrawn.
These key differences make it important to compare the two types. A common argument to use a traditional IRA and a 401(k account is that you will be in a lower tax bracket after you retire.
It is important to note that even if your future and current marginal tax brackets are equal, the aftertax income you will receive in retirement will be the same regardless of which type of account. If that is the case, tax considerations should not be a deciding factor.
Below is a table that shows 2018 marginal tax rates for married couples and single workers.
Remember that the taxable income amounts can be determined by subtracting the standard deduction amounts. These amounts have increased as a result of the new law:
If you are 65 years old or older, blind or disabled, you can increase your standard deduction by $2,600 if you are married and both of your spouses over 65. You can also add $1,600 if single.
How can you tell if your tax bracket will be lower when you retire than when you were working? This will depend on how much you have taxable income before and during retirement.
Keep in mind that your taxable income will exclude part or all your Social Security income, depending on how much you earn from all sources. 15% of your Social Security benefits will not be taxable for the highest earners. Many people will see a drop in their taxable income when they retire, especially if they don’t have a substantial pension from their employer or have modest retirement savings (which is common for millions of older workers).
Let’s take a look at some examples to show how the new tax rates could impact your decision to make Roth or traditional contributions.
Workers currently paying taxes at the 32% and 35% brackets could also be affected by the logic that applies to them.
Roth IRAs don’t have to be distributed at 70-1/2. If you don’t see a lot of tax savings from a traditional IRA, 401(k), or 401-k, you might consider a Roth IRA. This will allow you to have more flexibility once you turn 70-1/2. The RMD applies to Roth 401k accounts, but not if your Roth 401k account is rolled to a Roth IRA.
Some people may believe that the new tax rates will be as low as possible, even though they are subject to change under future Congresses. If the federal deficit grows rapidly, or if Congress allows new tax rates to expire in 2025 as the law currently stipulates, this could occur. This belief could be a strong argument to contribute now to a Roth IRA account or 401(k).
You can split your contributions between IRAs and 401(k) accounts if you are still unsure or confused about your marginal income tax rates when you retire.
These rules don’t apply to you, so make sure you are contributing to your IRA or 401k account. You’ll do better saving money for the future than spending it all now, no matter what your decision.
