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Retirement investing offers many perks. 

Of course, the primary perk is that you will actually have funds in retirement, but a very close second perk is the tax benefits that come with these accounts. 

Why pay the government more than you need to? Instead, take advantage of tax benefits, no matter which type of retirement account you choose.

1. Roth (Post-tax, After-tax)

I’m sure you’ve heard of a Roth IRA or Roth 401K, or even post-tax 401K. When you contribute to a Roth account, you contribute dollars that have already been taxed, post-tax dollars. 

Let’s say your paycheck gross amount is $2,000, but after taxes and insurance, you take home $1,200. For a Roth account, you would be contributing money from that $1,200. This money has already been taxed. Your total taxable income is still $2,000. 

Contributing to a Roth account doesn’t give you any tax benefits in the year you contribute to it.

However, the Roth accounts give you the most tax benefits overall because you do not pay any taxes on the amounts withdrawn during your retirement. 

Let’s say you contribute $150,000 over the next 25 years into your Roth account. This $150,000 has now grown to $475,000 due to compounding. This means you’ve had $325,000 of growth in the account. 

When you withdraw these funds from your contributions and your growth, you don’t have to pay any taxes. This is very different from the Traditional retirement accounts.

The more your account grows, the more tax savings you’ll experience with a Roth account. This is what makes the Roth accounts so appealing. 

You will save so much in future taxes by paying the tax today. 

Remember, growth will make up the vast majority of your account balances in the future. All this growth is tax-free in a Roth account.

2. Traditional (Pre-tax, Before tax)

The Traditional is the most common type of retirement account, simply because it’s existed longer than the Roth. The Traditional account allows you to get the tax benefit in the year you contribute to the account. 

In our prior example, if your paycheck was $2,000 and you contributed $500 to a Traditional account, then this $500 comes off your gross value before taxes are calculated.

In other words, you would only be taxed for receiving $1,500 on that paycheck. The immediate tax benefit is really appealing to people. I get it. You want the tax advantage as soon as you can get it. You’re making a choice between yourself today and your future self.

The problem with the Traditional account is when you’re retired, you’re going to pay a lot more in taxes. 

Let’s look at the same example as above. You contribute $150,000 over the next 25 years, and your account has grown to $475,000, so again, you have $325,000 in growth. 

When you start withdrawing from this account, you have to pay taxes on every withdrawal. That means, you have to pay taxes on the $150,000 that you previously received the tax benefit on and on the $325,000 growth. When you’re retired, taxes are the last thing you want to think about.

Many people argue that they are in a higher tax bracket while they’re working. Why wouldn’t they take the tax savings now instead of waiting until they’re in a lower tax bracket. Let’s do the real math.

This table shows the difference of this specific example. If you were to contribute $500 a month to a Roth and Traditional for 25 years and average an 8% return, you would pay far less taxes on the Roth over your lifetime. Even if your tax bracket does fall, it would take a significant tax bracket change to come out even.

This table says if you were in the 25% tax bracket during your working years, you would need to fall down into the 7% tax bracket in order to make the Traditional the right choice. If you were in the 15% tax bracket during your working years, you would have to fall to below the 5% tax bracket in order for the Traditional to be the right choice.

These are just the tax ramifications of the Roth versus the Traditional. The Roth has other conveniences as well, but we won’t dive into much of the detail here. There are income restrictions on the Roth accounts though. Consult your tax professional for more details.

If you have the option to contribute to a Roth 401K at your job, this is the highly recommended choice. Also, take advantage of the Roth IRA. Within certain income limits, almost anyone can open a Roth IRA.