Saving for retirement is essential. If you don't make an effort to build up a solid nest egg, you might end up seriously cash-strapped.
Much of that boils down to Social Security. Not only are benefit cuts on the table, but even without a reduction in benefits, Social Security will only replace about 40% of your pre-retirement earnings if you bring home an average income. Many seniors end up needing closer to 70% to 80% of their former income to maintain a comfortable lifestyle, and it takes personal savings to bridge that gap.
When it comes to finding a home for your savings, you have choices. You could opt for a traditional IRA or 401(k) plan and enjoy tax savings immediately or open a Roth IRA or 401(k) and enjoy tax savings later on. The question is, which route should you take?
When should you snag your tax break?
With a traditional IRA or 401(k), you'll get an immediate tax break on your contributions. But then you'll pay taxes on withdrawals in retirement.
Roth IRA and 401(k) plans work the opposite way. You won't get a tax break on the money you put into one of these accounts, but you'll enjoy tax-free withdrawals in retirement.
With a Roth, you'll also benefit from tax-free investment gains, whereas with a traditional savings plan, those gains are merely tax-deferred. That means you'll be taxed on them eventually.
It can be tempting to opt for a traditional IRA or 401(k) to enjoy tax savings right away. But that may not be the best move for your retirement.
Think about how burdensome it is to pay taxes now, while you still have a job and the potential to grow your income. Now imagine how tough it might be to deal with taxes later in life, when money is tighter.
How to make the right call
If you're not sure whether to fund a traditional retirement savings plan versus a Roth, you may want to ask yourself these questions:
Do I need a tax break to be able to save for retirement? If you're reliant on a tax break for the money to fund an IRA or 401(k), then you may want to stick to a traditional savings plan. But if you can swing those contributions, then you may want to set yourself up for tax-free income in retirement.
Do I think my tax burden will be higher now or in retirement? Some people end up with a higher income in retirement than during their working years. But other people see their income shrink in retirement. It pays to snag a tax break when your income is highest and your IRS burden is greatest. If you think you'll end up subject to a lower tax rate in retirement than today, then a traditional IRA or 401(k) could make more sense.
That said, we don't know what tax rates will look like down the line. We only know what they look like now. But the tax code has the potential to undergo many changes in the coming years and decades, so keep that in mind when making your choice.
Finding the right home for your retirement savings is important. When it comes to choosing between a traditional and Roth account, there's no right or wrong answer. And to be clear, it also doesn't have to be one or the other. You may decide to put some of your money into a traditional savings plan and house the rest in a Roth. That might give you the best of both worlds.