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By Suze Orman
Given we are in the heart of tax season I know many of you are focused on ways to save on this year’s tax bill. And you are grumbling that you are determined to reduce next year’s as well.
But I think when it comes to how you save for retirement, it can be smart to choose a type of account that doesn’t help you lower your tax bill today. Yes, you read that right: I am making a case for a retirement savings strategy that doesn’t deliver any immediate tax break.
I am talking about Roth Individual Retirement Accounts (IRAs) and Roth 401(k)s, which are different from Traditional IRAs and 401(k)s.
Hear me out on why I think saving in a Roth rather than Traditional accounts can be a big retirement win.
Our federal tax system offers incentives to get us to save for retirement. With retirement accounts, the incentive is a tax break. The biggest difference between a Traditional retirement account and a Roth retirement account is when you get your tax break.
In return for that tax break, you are making a deal with the federal government that in retirement you will pay income tax on every dollar you withdraw from traditional retirement accounts. (And as I explain below the federal government will force you to make withdrawals. It wants its tax revenue!)
I want to be clear that I think any and all retirement savings is great. There is nothing wrong with saving in Traditional accounts. I just think that there are plenty of reasons why saving in a Roth can be smart(er).
Here’s when I think Roths are a great move:
When you have yet to build up a very large emergency savings account I think a Roth IRA can be extra smart to consider. That’s because every dollar you contribute to a Roth IRA can be withdrawn at any time without owing any tax or penalty. (It’s just your earnings in a Roth IRA that you don’t want to touch-as they can be hit with tax and penalty). That’s different from a Traditional IRA where you will owe income tax on any withdrawals, and if you are younger than 59 ½ you will also owe a 10% early withdrawal penalty.
I want to be very very clear: I am not recommending taking money out of a Roth IRA before retirement. But when you’re still building up your emergency savings, it can help you sleep better knowing that in a dire situation you could withdraw Roth contributions without tax or penalty.
But you need to take the initiative to ask that your contributions be made to the Roth 401(k). Plans that automatically enroll new employees choose the Traditional 401(k) for them. All you need to do is ping HR and ask for your new contributions to be made into the Roth option. (I want to be very clear here: You do not want to move your existing Traditional savings into the Roth account. That will trigger a big tax bill. I recommend consulting a tax pro before you consider that move. What I am suggesting is that you make future/new contributions into the Roth 401(k) option.)
If you choose the Roth 401(k) and your company offers a matching contribution, I want you to be aware of an odd quirk: That matching contribution will be made into a Traditional account. Nothing you can do about it. But I just want you to know how it all works.
The question I get asked all the time is which is better. It depends.
A Roth 401(k) might be all you need to use if your plan offers investments that charge very low fees. Every fund in a 401(k) plan charges an annual fee called the “expense ratio.” If your plan offers index funds that charge no more than 0.10% or so, that’s great.
Higher expenses? Always contribute enough to the 401(k) to get the company match, but after you reach that level, I would recommend focusing on saving in a Roth IRA. Once you max out on your annual Roth IRA contribution it’s fine to contribute more to your Roth 401(k).
If your workplace plan doesn’t offer a Roth option, I always want you to contribute enough to earn the maximum employer matching contribution. But once you’ve hit that mark, you too should consider saving in a Roth IRA.
And if you’re reading this before April 15, 2022, I want you to know that you can still make a contribution to a Roth IRA for the 2021 tax year, up until the federal tax filing deadline. Anticipating a tax refund? I would put saving in a Roth IRA high on your list of smart uses for that money.
The information in this article is for general information only and is not intended to provide specific advice or recommendations for any individual, as each individual's tax situation and investment risk tolerance is different. While the information provided is based on our understanding of current tax laws, and has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. To determine which investment(s) may be appropriate for you and how you might potentially reduce your taxable income now or in retirement, consult with your tax professional and financial advisor to discuss your personal situation prior to investing.
Suze Orman is the author of 10 consecutive New York Times bestsellers, a two-time Emmy award winner, and your go-to for honest answers on everything finance. She is the most recognized personal finance expert in America today and host of the Women & Money (and Everyone Smart Enough to Listen) podcast. Suze is excited to be a contributor for Money Mentor.
Suze and Alliant teamed up to help Alliant members make the most of their life by teaching them to make the most of their money. New Alliant members are also eligible for The Ultimate Opportunity Savings Account.
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