There are a lot of places to stash your retirement savings — like a brokerage account, a 401(k), or a really, really big wallet (impressive but unwise).
For me, though, there’s one clear winner. And it’s not just one account, but a certain type of account.
Here’s where I’m putting all my retirement savings — and how I expect it to save me well over $100,000 in retirement.
The Roth account
A Roth account is a type of 401(k) or individual retirement account (IRA). We call these “tax-advantaged retirement accounts,” because they offer big tax breaks on your retirement savings.
When you put money into a Roth 401(k) or Roth IRA, you don’t get an immediate income tax deduction, as you would with a traditional 401(k) or IRA. However, once you reach age 59 1/2, you can start withdrawing money with no income tax. That’s a huge benefit for retirees living on a fixed income.
Furthermore — and this is where the savings really start to rack up — the investments you make through your Roth account are not subject to capital gains tax or dividend tax.
Typically, when you sell an investment that’s gone up in value, you’ll pay capital gains tax on your earnings. The rate varies based on your income and filing status, but most people pay 15% if they’ve held the investment for a year or longer. If you’ve held the investment for less than a year, your gains will be taxed at your ordinary income tax rate.
Dividend tax is assessed on any dividends you receive throughout the year — and a lot of retirees have dividend-heavy portfolios. The rate typically ranges from 0% to 20%.
In my case, I’d normally pay 15% on both capital gains and dividends. But because my retirement savings are in a Roth 401(k) and a Roth IRA, I’ll pay no taxes on either. Based on my current retirement savings and where I expect them to be in 25 years or so, these tax breaks could save me hundreds of thousands of dollars.
Why Roth instead of traditional?
As I mentioned above, a traditional 401(k) or IRA allows you to deduct your contributions from the current year’s income. So you get a tax break now instead of when you retire. You also pay no capital gains or dividend tax on investments held in a traditional 401(k) or IRA.
If you currently make more income than you expect to make in retirement (via retirement savings withdrawals), then in theory a traditional 401(k) or IRA is a better deal. It’s better to take a tax break on a larger income than a smaller income.
However, the future is uncertain, and I’d rather not worry about all the things that could throw my retirement plan off course. For example:
- Income tax rates could go up.
- Health issues or job market shakeups could force me to retire early.
- The stock market could tank right before I retire.
If any of the above happens, I’ll be happy that I’m not paying tax on my retirement income.
Want to invest for the future while earning huge tax breaks? Check out our list of the best IRA accounts and open a new IRA today.
Roth accounts aren’t for everyone
Not every employer offers a Roth 401(k). People who earn more than a certain amount can’t contribute to Roth IRAs, and those who are eligible can only contribute up to $7,000 per year (or $8,000 if they’re 50 or older). Read up on the Roth IRA rules to see if they’re an option for you.
The good news is that traditional 401(k)s and IRAs are fantastic retirement savings vehicles as well. Many employers offer traditional 401(k)s, and traditional IRAs are available to everyone. You can’t go wrong with either a Roth or traditional retirement account.
Unsure which option is best for you? You could always split your retirement savings between traditional and Roth accounts to enjoy some tax breaks now and some later. The best stock brokers offer both types of account, so you can manage your retirement savings in one place.
Personally, I choose to give my future self the gift of tax-free retirement income.
