What is the difference between a traditional and Roth account? Are there advantages to using one versus the other?
Saving for retirement is important, and there are plenty of account options available to assist in this goal. Traditional and Roth individual retirement accounts as well as traditional and Roth 401(k)s are among the more commonly used retirement savings vehicles. However, due to IRS income phase-out limits, many physicians are not eligible to contribute to a Roth IRA and cannot take advantage of the tax benefits associated with contributing to a traditional IRA.
Viable alternatives for physicians are traditional and Roth 401(k) and 403(b) plans. These accounts are often available to physicians through their employers and are not subject to the same income limits.
Unbeknownst to many investors, 401(k)s and 403(b)s are nearly identical retirement savings vehicles. Both have the same contribution limits and the same tax-deferred or tax-free benefits. The primary difference is that a 401(k) plan is only offered through a for-profit company whereas a 403(b) plan is offered through a non-profit organization.
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The mechanics of traditional 401(k) and 403(b) plans are fairly straightforward. You can usually make a pre-tax contribution of up to $18,000 each year ($24,000 if you are over age 50), and your employer may contribute additional money through either a fixed percentage or a match. Contributions are typically invested in mutual funds and/or exchange-traded funds, and grow tax-deferred (meaning you do not pay capital gains tax on any sales made that generate a gain). Once you reach age 59½ , you can take qualified distributions from the account. But since contributions were made pre-tax, you must pay ordinary income tax on any amount withdrawn from the plan.
There are no income limits that prohibit contributing to these plans, nor are there income limits that reduce the tax benefits. However, be aware that for high-income individuals earning over $270,000 per year, the maximum amount your employer can contribute is limited.
Roth 401(k)s and 403(b)s work in similar fashion to traditional plans; however, instead of contributing pre-tax dollars, you contribute post-tax dollars. This means federal and state taxes have already been withheld. Since you have already paid taxes on the contribution side, the funds grow tax-free, and withdrawals made during retirement are tax-free as well.
Next: Nuances to consider
There are some nuances to consider, however. First, the matching employer contributions must still be made in a traditional 401(k), not a Roth 401(k). You will still owe tax on withdrawals of amounts contributed by the employer into the traditional 401(k). There are no income limits impacting eligibility to contribute to a Roth 401(k) or 403(b), but as with traditional plans, there may be a limit on how much your employer is allowed to contribute.
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Whether to use a traditional or Roth account is not always an easy decision since it essentially requires you to predict the future. As a general rule of thumb, if you expect to be in a lower tax bracket in retirement than you are now, contributing to a traditional plan may be the best option. This is a common scenario for physicians. However, if you own or plan to own businesses or properties that will continue to generate income in retirement equal to or greater than you are earning now, contributing to a Roth 401(k) or 403(b) account makes sense.
Mutual funds range in size from tens of millions of dollars to hundreds of billions of dollars. As a fund grows, the list of companies that it invests in also tends to grow. This can be an advantage since it creates greater stock diversification, which may reduce price fluctuations within the fund. Remember that all funds start out small in size. A new fund has the ability to build a portfolio that reflects the manager’s view of attractive investments. A new, smaller fund is not burdened by tax issues related to previously held investments.
Some funds like being small and don’t want to become large. To preserve this perceived investing advantage, some funds actually close to new investors once they attain a certain size. As a general rule, when smaller-sized mutual funds gain in popularity due to stellar performance, they also gain in asset size. The unknown variable is how that fund will manage its growth.
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Send your questions about estate planning, retirement, and investing to Jeff Witz, CFP, c/o Urology Times, at UT@advanstar.com Questions of general interest will be chosen for publication. The information in this column is designed to be authoritative. The publisher is not engaged in rendering legal, investment, or tax advice.
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