IRAs and 401(k)s are powerful savings tools for your clients’ employees, but the tax implications can be difficult to understand. Knowing the ins-and-outs can make all the difference when getting your clients the information they need to make the best decisions about how to save. Here are three things to keep in mind:

 

Roth vs. Traditional IRA Taxes

If someone’s tax rate is lower now than it’s expected to be during retirement, a Roth IRA can be a great idea. “To account for that tax burden in retirement, a traditional IRA needs a larger balance to equal the value of a Roth IRA,” wrote Arielle O’Shea and Jonathan Todd for Nerd Wallet. “And since the contribution limit on these accounts is the same, the only way to build that larger balance at the maximum contribution level is to supplement it by contributing to a separate investment account.”

 

Therefore, if someone is a disciplined saver who plans to invest that up-front tax savings for retirement, he or she might come out ahead. “If you take that tax savings and absorb it into your budget — either because it simply reduces your tax bill come filing…or because you didn’t know the importance of investing it,” they wrote, “you would end up short of what you could have accumulated in a Roth IRA, no matter what your tax bracket.”

 

Using Traditional IRAs as a Tax Break

Savers contribute pre-tax dollars to traditional IRAs. However, the deductions one can take vary, wrote Dan Caplinger for The Motley Fool. “Traditional IRAs offer deductible contributions, but for those who are covered by a 401(k) or other employer plan or whose spouse is covered, income limits apply that can reduce or eliminate the deduction you can take for those contribution,” he wrote.

 

Factoring in 401(k)s

“Few retirement plans offer the ability to save more in a tax-favored manner than 401(k) plans, and in particular, 401(k) contribution limits dramatically exceed what you can set aside in an IRA,” Caplinger wrote for a different Motley Fool article. “With traditional 401(k)s, you can reduce your taxable income by contributing more to the retirement account, reducing your current-year tax bill,” he wrote. “With a Roth 401(k), you don’t get a reduction in taxable income now, but you can treat distributions later on as tax-free, never paying taxes on the appreciation or income earned in the Roth.”

 

These savings vehicles also waive the penalty on early distribution if one becomes disabled, and allow distributions to cover medical expenses of more than 7.5 percent to 10 percent of adjusted gross income, he wrote. “Just remember that regardless of whether the penalty applies,” Caplinger wrote, “you’ll still have to pay income tax on amounts withdrawn from traditional 401(k) accounts.”