While everybody needs to save for retirement, not everyone will use the same approach to doing so. Insofar as retirement accounts are concerned, you have two basic options to choose from: a tax-deferred retirement account, or a Roth retirement account. Here's how to decide which one is best for you.
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How tax-deferred accounts work
Tax-deferred retirement savings accounts, including the traditional 401(k) and IRA, work on the "save money now, pay later" system. When you contribute to a tax-deferred account, you don't have to pay taxes on the money you contributed, but you will have to pay taxes when you later take the money out.
When contributing to a 401(k) account, the tax savings happen automatically -- your contribution comes out of pre-tax dollars, then the remainder of your paycheck is used to calculate your income taxes. Getting the tax break on an IRA contribution is a bit more complicated, but it works out to much the same thing: You list the amount you contributed to traditional IRAs on your tax return, and you can deduct that amount from your income.
Note that if you have access to an employer-based retirement savings account, and your income is above a certain level, you won't be able to deduct your IRA contributions. In that case, you're better off sticking to 401(k) contributions to maximize your tax-deferred benefits.
How Roth accounts work
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Roth accounts are the opposite of tax-deferred accounts. With a Roth account, you have to pay taxes on the money you contribute. However, the money you take out of the account later is not subject to income taxes (although if you take the money out early, you generally have to pay a penalty).
If your income is above a certain level (in 2017, that's $196,000 for married filing jointly, and $133,000 for single or head of household), you're not allowed to contribute to Roth accounts. You won't lose anything you've already contributed to a Roth, you just can't add more. In that case, contributing to a tax-deferred account is your only option.
The tax benefits of both accounts
Both tax-deferred accounts and Roth accounts apply tax benefits to the investments inside the accounts. First, any dividends or interest paid into these accounts will not be taxed as they occur. Second, if you sell an investment inside such an account, you won't need to pay capital gains taxes no matter how much profit you made on the transaction.
Which account is better?
To decide which type of retirement savings account will save you the most on income taxes, you need to determine whether your income in retirement will be higher or lower than your current income. If it's likely to be higher, then a Roth account will save you more. But if it's likely to be lower, then a tax-deferred account will be the better deal.
The idea is to maximize your tax savings at the point when your income is at its highest. Higher income means a higher tax bracket, meaning that you'll be paying a higher percentage of income taxes. So, tax breaks will be more meaningful when your income is higher than when it's lower.
All of the above?
For many savers, the best approach is to have both types of retirement savings accounts. This gives you flexibility to choose between taxable and tax-exempt income once you retire and start tapping those accounts, which can open up new options for managing your taxes during those years.
For example, if your income in retirement is likely to be high and your money is in tax-deferred retirement accounts, then you could end up being charged taxes on your Social Security benefits. Having some of your savings in Roth accounts instead can save you from those Social Security taxes, as distributions from Roth accounts aren't considered taxable income and don't count toward the Social Security income threshold.
Another factor to consider is required minimum distributions, which will kick in when you hit age 70 1/2. RMDs are based on how much you have in tax-deferred accounts, but they ignore Roth accounts. As a result, having some money in Roth accounts will make your RMDs smaller, limiting unnecessary distributions (and the resulting taxes).
Splitting your contributions between tax-deferred and Roth accounts may end up saving you the most on taxes in the long run. You won't optimize your tax savings relative to your income level, but if having both types of accounts allows you to dodge Social Security benefits taxes and tweak your RMDs, you'll be awfully glad you set things up that way once you're retired.
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