When contributing to your IRA or 401(k) you can opt to either make these contributions as tax-deferred or as Roth. However, you might be wondering when should you choose one over the other? Or what are the differences and similarities in the 2 types of contributions? Or, even, what is “Roth” and what is “tax-deferred”?
Roth and tax-deferred money is subject to similar contribution and distribution rules. The main difference lies in the timing of when taxes are paid. For tax-deferred contributions, taxes have not been paid on the money you use to fund the account. Instead, you pay taxes when money is withdrawn from the account later on down the road. On the other hand, Roth contributions are made with money you have already paid taxes on. Thus, you do not have to pay taxes on distributions from Roth account and, as an added bonus, the growth in Roth accounts is tax-free.
Below is table that shows the main differences between the 2 types of contributions:
So, when should you choose one over the other? Well, typically, the younger you are, the more sense it makes to do Roth contributions. This is because Roth contributions are better when you expect your income to be higher in the future.
Below are the more common situations when each type of money might be more beneficial than the other:
Every investor and portfolio is different. So, while Roth contribution tend to be more beneficial younger investors, this might not be what is best for you. Additionally, financial situations can change from year-to-year, so the most beneficial option one year, might not be the same each year. Therefore, you should consult with your financial advisor to determine the best course of action regarding you and your portfolio, both for short- and long-term goals.