Traditional or Roth?

If you work for a company, chances are they offer a 401(k) retirement plan.  Some companies even offer a Roth 401(k).  Or maybe you're just looking at a traditional IRA vs a Roth IRA and don't understand the difference or which one you should invest in.

Yeah I ended that sentence in a preposition.  Big whoop, wanna fight about it?

In a nutshell, when you invest in the traditional 401(k), IRA or TSP it's done with pre-tax dollars, and you're taxed on the money when you withdraw it in retirement.  These plans have two benefits:

1) They reduce your taxable income.
2) More money gets invested earlier, and the returns compound.

Let's say you make 50,000 a year and contributed the maximum of $18,000 for 2014.  If you hadn't contributed, you would have paid over $5800 in taxes.  The contribution brings your taxable income down to $32,000, on which you would have paid $2800.  That $3000 difference would be invested and would go out to work for you.

For the Roth, you would be taxed on the entire $50k, but all the gains you earn on any money invested would be completely tax free when you withdraw in in retirement.  Let's say you invest $100 at 25, and withdraw that money at age 65 plus the approximately $2600 that the stock market would have made for you over 40 years.  The entire $2700 is tax free.

To know which type you should invest in, you need to ask yourself one question: Will your tax bracket be higher or lower in retirement than it is now?

If it's higher in retirement, you should put your money in a Roth.  If it's lower, you should invest in the traditional.  Of course, we have no way of knowing what the government will do decades from now, but you can probably estimate.  Generally, most people benefit from the traditional TSP, IRA or 401(k).  Two notable exceptions are people with low income and military folks.

If you're in the military, chances are you'll get deployed, and when you do, all the money you earn is tax free.  You would be better off putting that money into a Roth.  The Thrift Savings Plan offers a Roth version, so I'd recommend opening one of those vs the traditional.  Unless you know you'll never get deployed, in which case the traditional is better.  Or you may be able to open both, and allocate your money accordingly.

Of course, the best course of action would be to max out both accounts.  $18,000 for a 401(k)/TSP and $5,500 for a (Roth) IRA, but many people can't do that, so what you could do is just split your money between the traditional and Roth.