It’s never too early to start saving for retirement. Seriously. Even putting it off a few years can mean a difference of hundreds of thousands of dollars in savings available to you once you’re in your golden years. That’s the power of compound interest, folks.
That being said, you have a few different options for retirement accounts available to you. Two of the most common are a 401(k) or an IRA (Individual Retirement Account), but even then you have two types of each: traditional and Roth. So which one is right for you? We went directly to some of our favorite personal finance experts from around the Web and asked them which they recommended.
A little background
Before we jump in, it’s important to understand the difference between what Roth and traditional means for each of these retirement options. The most important distinction is when the money is going to be taxed. Traditional accounts are pre-tax; your contributions are subtracted from your taxable income, lowering the amount you’ll pay to the IRS come April. This seems pretty great, because no one enjoys paying taxes. However, there’s no such thing as a free lunch, so you’ll end up paying taxes when you withdraw the money in retirement.
A Roth account is essentially the opposite. You can contribute to your account but that money will still be included in your taxable income. However, when you decide you’re done with this "working" stuff and want to globetrot, you can withdraw the money without paying taxes on it.
There are a few other differences between traditional and Roth: eligibility age, income limits, contribution limits, withdrawal penalties (so the money stays hands-off until retirement), and so on. Our experts, though, all mentioned the tax rules surrounding traditional and Roth accounts as their X-factor in leaning one way or the other.
David Auten and John Schneider - Debt Free Guys
The Debt Free Guys David Auten and John Schneider, veterans of financial services and the authors of four books on various personal finance topics, told us that the type of account you choose depends on how much money you’re making.
"A Roth IRA is typically more appropriate for lower income earners and a Traditional IRA is typically more appropriate for higher income earners," Auten and Schneider said.
When you think about it, that makes sense, and it’s one of the determining factors for people. Consider this: when you’re younger, just starting your career, your salary probably isn’t something most people would be jealous of. As you get more experience, get promotions, and so on, your salary typically grows as you age. That also means, of course, that you’ll change tax brackets and will owe more to Uncle Sam each year.
Finance expert Jocelyn Wright gave similar advice.
"If you are young worker just starting out and/or expect to be in a higher tax bracket consider a Roth IRA/401(k). If, on the other hand, you expect to be in a similar tax bracket and need the deduction from your contribution to reduce your taxable income consider the traditional IRA/401(k). "
So if you’re a lower income earner – beginning your career, for example – you’d rather pay taxes now with a Roth account, at a lower income bracket, than later, when you’ll owe more. Similarly, if you’re a higher income earner, starting with good pay or getting started a little later in investing, you won’t need to worry about owing significantly higher taxes on withdrawals than you will on contributions and a traditional account would be more appealing for the initial tax breaks.
Shannah Game - Your Millennial Money
Shannah Game, blogger and host of the Millennial Money podcast, gave a good analogy for the different methods of taxation. With a Roth account, you’re "taxed on the seed and not the harvest," while with a traditional account you’re "taxed on the harvest and not the seed, so it’s a great option for someone who might need tax-deductibility now."
Game also said that "if you have access to a 401(k), that’s probably your best bet because you can save more, and often times your company will offer matching contributions, which is literally free money. IRAs let you contribute up to $5,500 per year ($6,500 if you’re over 50 years old), but with a 401(k) you can contribute up to $18,000 ($24,000 for those 50 and older) – plus, as Game mentioned, you may be able to get matching employer contributions.
Still, Game says you shouldn’t have to choose between and IRA and a 401(k), and that "when it comes to retirement savings the more the merrier is the name of the game."
Andrew Meadows - Ubiquity
Andrew Meadows, the VP of Brand and Culture at retirement specialist Ubiquity, knows how hard it can be for individuals to choose between a traditional and Roth account. "It’s like having to choose a favorite child or parent," he said. Like Auten and Schneider, Meadows said the choice relies heavily on the tax implications of each.
"Since we’re all planning on retiring wealthy (right?), the advantage of the Roth IRA is that you don’t have to worry about being taxed in a higher tax bracket in retirement," said Meadows. "However, if you prefer compound interest, you’ll want all that pre-tax money in your traditional IRA to help the Georges become Benjamins."
Meadows called that the "politically correct answer." His take on traditional accounts, however, made an interesting point: "Compound interest may seem like magic, but it’s MATH! If you’re saving money pre-tax (traditional IRA), the more money you have in your account, the more it’ll grow!"
Investing in general often seems like magic, and that’s what makes people stall instead of jumping in. They feel like investing is beyond their ability to understand, but like Meadows said, it’s just math. There’s no reason to be scared of it, especially since waiting because you’re apprehensive can lead to lost earnings.
That leads nicely into our final piece of advice: just do it.
J. Money - Budgets are Sexy
J. Money does two interesting things in the world of personal finance blogs: he rocks a mohawk, and he publicly tracks his net worth over on Budgets are Sexy to teach people how to pay attention to their finances. He’s on the "invest now" bandwagon; he like both traditional and Roth options, as long as you choose one.
"It doesn't matter which you choose as both of them are GREAT!" he said. "The worst decision is not choosing anything at all to invest your money in."
He’s right, of course. First of all, savings accounts are lazy for you and your money. If you just throw your money in one, it’ll earn minimal interest and not be worth much more in retirement than it was while you were working. Compared to the interest you’ll gain by investing that money, you’d be crazy to not put it into a 401(k) or IRA, regardless of the type.
Not investing is silly, but waiting isn’t a much better choice. It’s something we’ve talked about before: if every dollar you invest when you’re 22 years old is worth $17 when you retire, that same dollar will only be worth $10 if you wait until you’re 30, and only $7 if you wait until you’re 35. Now, 35 isn’t old age by any means, but in terms of investing it pretty much makes you a grandparent. You’ll find yourself complaining about those young whippersnappers and their newfangled investment strategies.
There’s a reason it’s called personal finance – so many decisions depend on the person or people involved. "It depends" isn’t the answer a lot of people want, but it’s more about giving you the tools and resources to make a decision that’s right for you. So should your retirement account be traditional or Roth? Well...it depends! But now that you know the difference, you’ll be able to take a look at your finances in a more educated light and make the choice that fits you.
Image: Raymond Bryson