Not sure what type of Individual Retirement Account (IRA) is right for you? You’re not alone. Both traditional IRAs and Roth IRAs offer unique benefits, but you’ll need to consider your financial goals to determine what’s right for you.
Tax deductible vs. tax deferred
When comparing traditional IRAs and Roth IRAs, taxes are a key difference between the two types of accounts. Traditional IRAs offer a potentially tax-deductible way to contribute to your retirement, in which your contributions and earnings aren’t taxed until they’re withdrawn. In contrast to a traditional IRA, a Roth IRA is an individual retirement account in which your contributions are made with money you’ve already paid taxes on, allowing “qualified withdrawals” of earnings that are tax- and penalty-free.
Future and current tax brackets
Your tax bracket is the tax rate for the range of income you’re reporting on your federal income taxes. The more reported income, the higher the tax percentage. Your current tax bracket is easy to figure out by looking at your latest tax return, but your possible future tax bracket is probably harder to imagine. For comparing the advantages and disadvantages of traditional and Roth IRAs, it’s handy to have at least an idea of whether your future tax bracket will be higher or lower than your current one.
With a traditional IRA, you’re getting a potential tax deduction now, but in the future you’ll have to pay taxes at whatever tax bracket you’re in when you start your distributions. If you believe that your tax bracket will be lower in the future than it is now, there may be a tax advantage to investing in a traditional IRA. (For specific income and contribution rules and limitations, go to Traditional IRAs.)
With a Roth IRA, you’re contributing with money you’ve already paid taxes on so that money is not taxed at withdrawal, and everything the account earns can be taken out free of taxes after the account has been open for five years and you’re at least age 59½, disabled, purchasing your first home (a $10,000 lifetime limit), or you’ve inherited the Roth IRA.
If you anticipate that your tax bracket in the future will be higher than now, the Roth IRA may be a good option for you. (For specific income and contribution rules and limitations for Roth IRAs, go to Roth IRAs.)
Best of both worlds
Can’t choose? You can actually contribute to both types of IRAs if you want to take advantage of the unique benefits each account offers. The annual contribution limit can be split between your IRAs. And if you currently have a traditional IRA and decide a Roth IRA would be a better fit, you can always convert your traditional IRA account into a Roth.