When you’re investing for retirement, be sure to think about this downside.
- A 401(k) and an IRA are common accounts used to invest for retirement.
- There are advantages to putting your money into these accounts, like getting an upfront tax break.
- Unfortunately, that means you’ll pay taxes on your withdrawals.
If you are investing money for retirement, chances are good that you’re putting it into a traditional 401(k) or into a traditional IRA.
These accounts have some big advantages. Both offer upfront tax breaks so you get to deduct the amount you contribute to them in the year that you make the contribution. If you are investing in a 401(k), there’s also a good chance your employer will match your contribution, while if you’re investing in an IRA, you get your choice of brokerage firms and have access to a wide selection of investments.
While these benefits make traditional retirement plans attractive, finance expert Dave Ramsey has pointed out that there’s also an important downside to these types of investment accounts that you should consider.
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Traditional IRAs and 401(k)s come with a catch
According to Dave Ramsey, the big downside of traditional retirement plans comes when you are actually a senior and you begin relying on the money from these accounts.
“You’ll have to pay taxes on the money you take out of your traditional IRA in retirement,” Ramsey explained.
See, while you enjoy an upfront tax break in the year you contribute and tax-free growth, withdrawals are not tax free. You’re taxed on the money you take out at your ordinary income tax rate in your later years. This means that you have to give the IRS a cut of your fixed income.
Instead of committing your future self to paying these taxes, Ramsey recommends an alternative retirement investing account.
“We recommend investing with a Roth IRA instead,” the Ramsey Solutions blog reads. “Roth IRAs are funded with taxed income. You won’t be able to deduct Roth contributions off your taxes now, but who cares? You’ll be too busy enjoying tax-free growth and withdrawals in retirement later. Future you will thank you!”
Should you listen to Ramsey?
Ramsey is right to point out that the taxes you’ll have to pay in retirement are a big downside when you invest in a 401(k) or IRA.
Not only will the distributions you take be subject to taxation, but the money you withdraw is also going to be counted when determining if your income is high enough that you’re taxed on Social Security benefits. Distributions from a Roth don’t count in this calculation, though, so you’re more likely to be able to enjoy tax-free Social Security checks if you opt for a Roth.
However, the tradeoff is that you do get that upfront tax deduction. And since you can claim the deduction when you invest, it makes it easier to find the money to contribute because each dollar you put into your 401(k) or IRA doesn’t reduce your take-home income by as much as an investment in a Roth would.
Ultimately, you’ll want to think carefully about when it makes sense for you to claim your tax break. If you are struggling to contribute to retirement accounts now, you may not want to make it harder on yourself by deferring your tax savings until later. Likewise, if you think your tax bracket will be lower in retirement than it is now, it doesn’t make sense to wait to claim your savings.
But, if you have plenty of money now and aren’t sure you will as a senior — or if you think your tax rate will be higher later on — then getting a Roth IRA might be best. You do, however, always want to invest enough in your 401(k) to earn your employer match before moving on to contributing the rest to your Roth, if that’s the right account for you.
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