We get the question a lot from clients of all ages and walks of life of whether they should contribute to a Roth or a Traditional IRA. Everybody’s situation is unique, but there are some things we can consider:
- Current age
- Investment time horizon
- Current income tax bracket
- Future projected tax bracket
Roth and Traditional IRAs each have some unique benefits. The key difference between the two account types are in the timing behind when the IRS asks you to pay taxes. With Traditional IRAs (or any tax-deferred account for that matter, i.e Traditional IRA, 401k, or 403b) contributions are made with pre-tax dollars. This means you can automatically defer part of your paycheck to Traditional IRAs without that money being taxed. Roth contributions are made with after-tax dollars.
Based on that information, it seems like a no brainer to choose Traditional IRA over Roth, right? Not so fast.
While you are not paying taxes on the front end, with Traditional IRAs you are paying taxes when you take withdraws in retirement. That’s not the case with Roths. With Roths the money is allowed to grow within the account tax-free, and withdrawals are also made tax-free.
In other words, while the Roth IRA doesn’t provide an immediate tax benefit like the Traditional, it comes in really handy in retirement to have an account that provides tax free income — especially since the account should hopefully be much larger than what your contributions were if the money is invested properly over the years.
Below is a breakdown of the differences:
- Contributions are tax-free
- Growth in the account will be taxed when withdrawn
- Withdrawals at retirement age are taxed at regular income tax rates
- Required minimum distributions required at age 72 (70 and 1/2 if you turned 70 and 1/2 before Jan 1, 2020)
- Contributions are made with money that has already been taxed
- Growth in the account will be untaxed
- Withdrawals at retirement age are tax-free
- No required minimum distributions
Coming back to the original question: which is better? As you can see, each has a unique set of tax benefits. Generally speaking, the younger investors with a longer-term investment time horizon stand to gain more from Roth contributions than older investors. The reason is because the investments have more time to grow tax-free within the Roth the younger the investor is. At some point the benefit of tax-free growth and withdrawals outweighs the benefit that Traditional IRAs provide with tax-free contributions.
That being said, what we typically recommend is having a mix of accounts to tap into in retirement. This diversifies your income sources so your eggs aren't all in one basket. Roth contributions have income thresholds to qualify for contributions as well as annual contribution limitations. Therefore you might not have a choice but to diversify the way you are contributing to your retirement savings. Let us know if you have questions specific to your situation!