Note, however, that if the employee puts $20,000 in a standalone Roth, the employee must contribute from salary $20,000 after-tax and therefore must pay $6,000 of income tax from other funds. With a $20,000 contribution to a standalone Roth, the employee will have $20,000 in the Roth account. Then, the balance of $14,000 is the amount in the employee’s “Roth” within the traditional account. That is because, as noted, the traditional account can be looked at as though the government collects the tax due on a marginal $20,000 of earned income and invests it in the joint venture. With a $20,000 contribution to a traditional account, the employee will effectively only have ownership of a portion of the $20,000 (the employee’s “Roth” within the $20,000 traditional account). ![]() If an employer offers a standalone Roth account and the employee can spare the cash, the employee will get “more bang for the buck” by contributing the maximum to the standalone Roth instead of the traditional account. Standalone Roth Account Advantagesįirst, the tax law imposes the same maximum annual contribution limit to standalone Roth accounts and traditional accounts. Nonetheless, in at least one situation the traditional account is superior. Which Is Better, the Traditional Account (with “Roth” Within) or the Standalone Roth Account?Īlthough the two are similar, the standalone Roth has some advantages, including the three discussed below (again initially assuming the government’s ownership percentage (tax rate) is the same at contribution and withdrawal). Like the “Roth” within the traditional account, the standalone Roth account is exempt from all income and capital gains tax. Some tax on capital asset returns is more than zero tax on the “Roth” within the traditional account. For example, common stock dividends are subject to income tax-for individuals, generally as part of the net capital gains calculation at the adjusted net capital gains rate, which can be as low as zero depending on total income. In contrast, even with no realized capital gain, distributions on a capital asset might be taxable. The part of the venture the employee/retiree owns is exempt from all income and capital gains tax and is in effect a “Roth” within the traditional account. ![]() For simplicity, this article initially assumes that the ownership percentage (tax rate) is the same at contribution and withdrawal. At withdrawal, that ownership portion is determined by the tax rate at the time: the government’s ownership proportion could therefore be lower or higher than the government’s original percentage contribution. It is as if the government collects that tax and then invests it in the joint venture.Īt eventual partial liquidation (withdrawal), the so-called “income tax” collected by the government is really its ownership share created by that investment. When the employee initially invests, the government also can be thought of as putting up money-the otherwise-owed income tax on the earned income. ![]() The traditional account is in effect a joint venture between the employee/retiree and the government. This article discusses three investments ranked in order of increasing tax efficiency: taxable assets, traditional 401(k)/IRAs (traditional accounts), and Roth 401(k)/IRAs (standalone Roth accounts). It is worth noting at the outset that retirement accounts are extraordinarily efficient for tax purposes. With any increase in personal income or capital gains tax rates, taxable assets become even less tax-efficient relative to both the “Roth” within the traditional account and the standalone Roth account.
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