IRA and 401k Tax Deductions

Whether you elect to use an Individual Retirement Account (IRA) or company retirement account (401k), you will receive tax incentives to make contributions to your savings. The type of deductions you receive depend on the type of retirement account you select. Both traditional IRA accounts and traditional 401k accounts offer deductions in the present tax year. Roth IRA and Roth 401k options offer deductions in the future. Consider the benefits each can offer when deciding which option is best.

Traditional IRA and 401k Tax Deductions

A traditional retirement savings account offers you the option to deduct your contributions in the current tax year. When you file your taxes, you will enclose information showing the contributions you made. This amount will be deducted from the taxable income you earned. As a result, your income will be lowered, resulting in lower taxes owed in the current year. Then, the sum in the account will grow on a tax-deferred basis. When you withdraw the funds, you will be required to pay taxes. This requirement is due to the fact you have yet to pay any taxes on this income. You will pay the taxes at the tax bracket you fall into when the withdrawal is made.

Roth IRA and 401k Tax Deductions

A Roth retirement account works backwards from a traditional account. In the current tax year, there is no advantage to placing funds into the account. You receive no deduction, meaning you will place post-tax dollars into the account. Then, the sum of money in the account grows tax free, the same as a traditional account. The second difference happens on the back end. When the funds are withdrawn, since you have already paid tax on the income, you owe no taxes whatsoever. This means you will take the money out, regardless of your tax bracket, without owing a single dollar on the funds you contributed. 

Which Is Best?

There is no one answer to which is the best option. You should ask yourself which presents the greatest earnings potential to you. If you have a small income today, you are likely in a low tax bracket. This offers incentive for the Roth option. You will pay taxes on the savings in your current low tax bracket, and you will owe nothing when you are in your future, higher tax bracket. If you are already established in your career and paying a high taxes, it is likely you will actually fall into a lower bracket in the future. In this case, opting for the traditional option would be preferable. 

One other matter you must take into account is necessity of the moment. While long-term planning is advised, at times, current necessity is of greater importance. For example, if you considering buying a home in the next year, having the tax savings right now may be extremely important. The same goes for individuals who are paying for college, families and other major expenses. They may be more able to shoulder the tax in the future, even if the tax is slightly higher. 

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