Traditional or Roth account—two tips for choosing

Tax rates and how you manage money can help when figuring out which account may be right for you.

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Key takeaways

Choose between paying taxes now or in retirement. A tax benefit when your rate is the highest makes sense.

How good you are about saving is something to keep in mind.

Having both a traditional and a Roth account (if you can) may be appropriate.

How do you choose between a traditional and Roth IRA? If you work for a large employer, you may be able to contribute to either a traditional or a Roth 401(k) or 403(b), or both. If you’re self-employed, or if a 401(k) isn’t offered where you work, you may need to choose between a traditional or Roth IRA, or both.

While a 401(k), 403(b), and IRA are different types of accounts, the basic principles of a traditional and a Roth account apply to all. So, how should you choose between a traditional and a Roth account? Here are two tips to keep in mind.

Tip 1: Tax rates: higher now or later?

One key difference between a traditional and a Roth account is taxes. With a traditional account, your contributions are pretax. They generally reduce your taxable income and, in turn, lower your tax bill in the year you make them. Consequently, you’ll typically pay income taxes on any money you withdraw from your traditional 401(k) or IRA in retirement.

A Roth account is the opposite. Contributions are made with money that has already been taxed (your contributions don't reduce your taxable income), and you generally don’t have to pay taxes when you withdraw the money in retirement.1 This means you need to choose between paying taxes now or in retirement. You want to get the tax benefit when you think your tax rates are going to be the highest. In general:

  • If your tax rate will be significantly higher in retirement, a Roth account may make sense, because qualified withdrawals are tax free.
  • If your tax rate will be significantly lower in retirement, a traditional account may be more appropriate, because you will pay a lower tax on your withdrawals.
  • If you have no idea what your future tax rate will be, Tip 2 below, or how you manage your money can help.

Tip 2: Money style: spender or saver?

Do you live paycheck to paycheck or make saving a priority? How you manage your money can help you choose which type of account may make sense for you.

Traditional 401(k) and IRA contributions leave money in your pocket because they, generally, lower your current taxable income. But these tax savings can help you reach your retirement goal only if you invest them. If you get a tax refund and spend it, it’s not going to help you when you retire.

On the other hand, a similar contribution amount to a Roth account reduces the amount of money left in your pocket, because you pay taxes on your contributions up front. If you’re like many people who spend their paychecks, having less available to spend and saving more might be a good thing when it comes to your retirement savings. Plus, because you’ve already paid your taxes, you get to take your money out tax free in retirement,1 which could leave you more to spend later.

What about both?

It may be appropriate to contribute to both a traditional and a Roth account if you can. That can give you taxable and tax-free options when it comes time to take withdrawals in retirement.

If your employer provides an employee match or profit-sharing contribution, those contributions are typically to a traditional 401(k)—even if you are making only Roth 401(k) contributions. So you may already be contributing to both types of accounts. Check with your employer to be sure.

Deciding

It’s important to think about your current and future tax rates when contributing to a 401(k) or IRA, but it also helps to know yourself and the way you handle money.

What about both?

It may be appropriate to contribute to both a traditional and a Roth account if you can. That can give you taxable and tax-free withdrawal options when it comes time to take withdrawals in retirement.

Financial planners call a strategy of using both types of contributions tax diversification. It can make sense for those who aren’t sure about their future tax picture. Plus, it gives you the ability to manage your tax brackets in retirement.

It’s important to note that if you get an employee match or profit sharing contribution from your employer, those contributions are typically to a traditional 401(k)—even if you are making only Roth contributions. So you may already be contributing to both types of accounts. Check with your employer to be sure.

Deciding

So the message is this: It’s important to know the numbers and think about your current and future tax rates when planning for retirement. It’s important to know yourself and the way you handle money, too.

Act

Plan

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1. A distribution from a Roth 401(k) is tax free and penalty free, provided the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, disability, or death. A distribution from a Roth IRA is tax free and penalty free, provided the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, disability, qualified first-time home purchase, or death.
Investing involves risk, including the risk of loss.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
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