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Roth or traditional IRA or 401(k)?

How you feel about money can help you figure out which account may be right for you.

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Are you a big spender or a saver? Do you live paycheck to paycheck or make saving some of it a priority? Your answers could make some ways of saving far more effective for you than others.

What shapes your financial personality? How much you know about investing is just one factor, according to Eric Gold, vice president of behavioral economics at Fidelity. “For most people, spending, saving, and investing are a combination of their understanding of the topics and their emotional and psychological relationship with money.”

Some people micro manage their finances. They are organized, disciplined, and methodical about their money and are generally better about saving some of it, notes Gold. And they also value waiting for something rather than insisting on immediate gratification.

Then there are their polar opposites. They are more impulsive, and place a greater value on enjoying their money in the here and now. “Many of us are more impatient and want quick rewards,” says Gold.

How you feel about money is one way to help you choose between a Roth (after-tax) or traditional (pretax) IRA, 401(k), or 403(b).

Future taxes and discipline

The key thing to think about when choosing between a Roth or Traditional account is your tax rate today and what you think it will be in retirement. If you think your tax rate will be higher when you retire, an after-tax contribution to a Roth IRA or 401(k) may make sense. If you think your tax rate will be lower in retirement, a traditional IRA or 401(k) may be more appropriate. But, it is pretty hard to know what your tax rate will be—especially if retirement is 20 years away.

But tax rates don’t tell the whole story. “How disciplined you are at saving can also play a role in which type of account may better help you prepare for retirement,” says Matthew Kenigsberg, vice president of Financial Solutions at Fidelity.

Here’s why: Generally, contributions to a traditional IRA, 401(k), or other workplace savings account can help lower your taxable income (if certain requirements are met). For 401(k) contributions, the money is taken out of your paycheck before taxes are applied. With an IRA, you deduct your contribution on your tax return. This gives you more money in your pocket, but these tax savings can only help improve your retirement savings if you’re disciplined enough to put them into your retirement account. If you get an income tax refund and go out and spend it, it’s not going to help your bottom line, when you retire.

With Roth contributions—to an IRA or 401(k)—you pay taxes on your contributions up front. That takes away from your disposable income or current paycheck, because more tax will be taken out. With a Roth 401(k) your contributions and your taxes are coming out of your paycheck each pay period. With a Roth IRA, your contributions come from after-tax savings. But, if you’re like most people, who tend to spend what they earn anyway, having less disposable income might be a good thing when it comes to your retirement savings. You’ve already paid your taxes, so you get to take your money out tax free,1 which could leave you more to spend in retirement. "In a sense," says Kenigsberg, “a Roth 401(k) forces you to save more for later by keeping less in your pocket now.”

An example

Consider this hypothetical example. While our example uses a traditional and Roth 401(k), the same principles apply to a traditional or Roth IRA. Meet three hypothetical investors—Brian, Sara, and Sam. They all are 45, married, and plan to retire at 65. But, they are very different when it comes to their money.

Brian is frugal and a relentless saver. His contributions to a traditional 401(k) come out of every paycheck. He tracks every penny, and if he has some money leftover at the end of the month, he invests all of it. Same goes for tax returns, bonuses, and any windfalls.

Sara, like a lot of people, spends her paycheck. She also automatically contributes to a traditional 401(k), but when she gets a tax refund or has money left over from her paycheck, she doesn’t save a penny. Instead, she goes out to dinner, takes vacations, and buys new clothes regularly.

Sam has a lot in common with Sara. He’ll spend his money if it is available on his debit card. He contributes to a Roth 401(k) at work. He likes the idea of not having to pay taxes on the money when he uses it for retirement.

That said, let’s run some numbers.

They each have a $5,000 balance in their 401(k)s when they are 45 years old and plan to keep it in the account until 10 years after they retire, when they are age 75. That’s a 30-year time horizon. Brian and Sara both receive a $1,400 tax refund because they made traditional 401(k) contributions. Sam doesn’t receive a refund because his Roth 401(k) contribution doesn’t reduce his taxable income.

How much would they each have after 30 years, based on the type of 401(k) account they chose, and whether they saved or spent their tax refund? Take a look:

As you can see, Sara has the lowest balance since she chose the pretax 401(k) but spent her entire refund. Her account grows just like Sam’s, at 7% annually, but she then has to pay more than $10,657 (or 28%) in taxes when she withdraws the money in retirement.

Brian does much better than Sara because he invested his tax refund. After paying taxes in retirement, he ends up with the same $27,404 from his 401(k) that she does, but he had also invested his refund in a taxable brokerage account. In this example we assume Brian’s taxable account will have grown at 6% annually. Why the lower rate? Because as Brian invests, he may have to pay taxes. For this example, we are estimating those taxes will reduce his investing performance from 7% to 6%. At 6%, Brian will have $8,041 in his taxable account, so he’ll have a total of $35,445.

Sam does even better than Brian—the $5,000 in his Roth 401(k) has also grown at 7% annually, to $38,061, and he doesn’t have to pay any tax on withdrawal.

In effect, the Roth 401(k) gave Sam two big advantages that account for the difference: First, the Roth captured all of Sam's tax savings—safe from his temptation to spend it before retirement. And second, all of Sam’s assets were in the retirement account earning the highest rate of return in this hypothetical example.

Of course, Sarah could make up the difference by boosting her contributions. But that is not necessarily an easy task. She needs to have enough room below the yearly contribution limit, know how to do the math, and remember to do so. That said, increasing her contributions from $5,000 to $6,944 would leave her with the same balance as Sam.

This example shows that a Roth 401(k) might actually be an easier way to reach your savings goals by 1) making you pay your income taxes at the same time you contribute, 2) limiting the disposable income available for you to spend, and 3) allowing you receive tax-free distributions and potentially make a higher return on your investments. “Given that most people tend to spend what they earn more quickly,” says Gold, perhaps having less in your pocket now leads to more later.” If tax rates were lower in retirement, however, the analysis would change and the Roth may not be the easier option for reaching your saving goals.

Clearly, many factors determine what might be the best way for you to save for retirement—from what you can afford to your risk tolerance and tax situation. You might not typically think beyond numbers and facts to make saving decisions, but, given this illustration, maybe you should.

Personality can play a role in how effectively you save for the future—not just in terms of whether or not you save, but more importantly how you do it. And that gives a whole new meaning to the idea of “personal” finance.

Learn more

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1. A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, death, disability, qualified first-time home purchase.
Investing involves risk, including the risk of loss.
The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
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