The type of retirement account you choose to invest in will make a huge impact in how you access your money — and how much income your account provides — once you become a senior.
Unfortunately, far too many people end up selecting an account intended to secure their future based on an assumption that may very well be incorrect. Here’s why.
Are you making this faulty assumption when deciding which retirement account is best for you?
Far too many people opt to invest in a traditional 401(k) or IRA based on an assumption they make about their taxes. Specifically, both workers and many financial experts firmly believe that retirees are likely to end up in a lower tax bracket.
If this is the case, a traditional account likely makes the most sense because it provides an up-front tax break. Roth accounts, on the other hand, defer tax savings until later.
With traditional accounts, contributions are deducted from taxable income in the year you invest in your account. So if you’re in the 22% tax bracket, you’d save up to $220 on your tax bill for each $1,000 invested in one.
With Roth accounts, you don’t get to deduct contributions. You save nothing on each investment in the year it’s made. But you benefit from tax-free withdrawals. If you expect your tax rate to fall to 20% as a retiree, you’d save up to $200 for each $1,000 withdrawn. This is less than the $220 in savings a traditional account could offer, so you’d be better off with the up-front savings.
The only problem: The assumption that your tax rate will fall could very well be wrong.
Why you can’t count on your tax rate going down
There are a few big problems with assuming you’ll automatically be in a lower tax bracket as a retiree.
First and foremost, many people think they’ll end up in a lower tax bracket because their income will be lower in retirement. But this isn’t necessarily the case. Many retirees spend as much, or more, than they did before leaving the workforce. If your taxable income in retirement is close to the same as it was while working, you can’t assume you’ll be in a lower tax bracket later.
Second, there’s a good chance the government will raise taxes as time goes on. Tax increases are likely because:
- Rates are very low right now by historical standards.
- Younger generations have generally expressed more support than older generations for government programs that would require tax increases to support them. As this demographic group takes more political power, an expansion of government may lead to higher taxes.
- An aging population will raise the cost of popular programs such as Social Security and Medicare, requiring more government support.
- The deficit and debt are both growing, and paying them down may eventually become a bigger priority.
Since there’s solid reason to believe tax rates may rise across the board, many future retirees may end up in a higher tax bracket even if their income does go down.
As a result, it’s best not to assume that traditional accounts are always going to provide more tax savings. Instead, you may want to hedge your bets by putting some money in both traditional and Roth accounts. Or you may want to do a little more research into determining how your personal tax situation is likely to change over time so you can develop an individualized approach that’s right for you.
