Having enough money to last you until retirement is a goal for most people, but what is the best saving strategy? As it turns out, the type of retirement account you select can affect how much your money is worth.
A new report from the American Accounting Association investigates whether it’s better to pay taxes on retirement accounts when you invest the money or later, when you withdraw it. Specifically, it compares the length of retirement savings for people with tax-deferred accounts like 401(k) versus those with currently taxed accounts like Roth IRAs. The results may come as a surprise.
Roth IRA vs. 401(k)
Overall, research indicates that prepaying taxes on retirement accounts will help retirees spend their money longer than those who pay later. Currently taxed accounts like Roth IRAs tend to outlast tax-deferred accounts like 401(k)s with similar balances, the report finds.
The researchers tracked about 350 participants who maintained a tax-deferred account or a tax-current account with equal balances. Money in a tax-deferred account, such as a 401(k) or traditional IRA, is not taxed until it is withdrawn. Money in a currently taxed account, such as a Roth IRA or Roth 401(k), is taxed when it is invested, rather than when withdrawn.
What the researchers found was that participants spent money at similar rates regardless of account type. As a result, those who used tax-deferred accounts tended to deplete their savings more quickly than those who used tax-current accounts.
These findings help illustrate a key difference between two different types of retirement accounts and show how the account choice you make could affect how long your money lasts. One way to think about this is to think of a tax-deferred account as an account with “fees” – taxes paid upon withdrawal. The problem is that tax-deferred account holders may not take into account how much they will end up paying these fees, so they are prone to running out of money more quickly.
“Our findings suggest that people with tax-deferred accounts may need to save more than they think, unless they have confidence in their ability to account for taxes when making spending decisions in retirement,” said Marcus Doxey, professor accounting associate at the University of Alabama and co-author of the report.
The point is that it seems safer and easier to manage your retirement money if it’s in a currently taxed account. Paying your taxes early can be painful, but it’s better than running out of money too soon.
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