When opening up an investment account, your first choice to make will be whether to open up a ROTH IRA or Traditional IRA. Whats the difference? Which is better for you? Here we find out.
This is also the topic in our latest video, check it out below:
A quick summary of the video above:
Taxes, Taxes, Taxes
The primary difference between these accounts is their treatment of taxes.
A Traditional IRA (Or mostly just referred to as a ‘IRA’) defers taxes until the time the money is withdrawn from the IRA.
When you make a contribution to an IRA you get a tax credit equal to that amount, so effectively you pay no taxes on that contribution. However, when it comes time to take money out of the account, the distribution will be taxed at your current income tax rate.
For a ROTH IRA, there is no immediate tax advantage. All taxes are paid before the money goes into the account. But, when it comes time to take money out of the ROTH IRA, you pay no taxes at all.
This means that what account is right for you depends on your current tax rate and expected future tax rate.
If you are currently in a higher tax bracket than you expect to be in at time of retirement, a traditional IRA may suit you better.
If you are currently in a low tax bracket, but expect to be in a higher tax bracket later in life, a ROTH IRA may suit you better.
2013 tax brackets are shown below:
In the video above, there are several examples showing scenarios where a ROTH may be better, or where an IRA may be better. Those examples are good in hindsight, but what if you don’t know what your future tax rate is going to be? (Like most of us…)
Tax Diversification
If you are like the majority of investors your 401(k), or TSP for government workers, is your primary source for retirement savings. 401(k)s have a tax structure similar to an IRA where your money is invested pre-tax, and is then taxed as income upon withdrawal. This means for investors who are able to save a little more, having a ROTH IRA could give you considerable advantages come time for retirement.
By having a ROTH IRA and an IRA/401(k), you would be in much better control of your tax bill in retirement.
For example:
If you retire and want to delay social security for a year or two, taking distributions from an IRA may be advantageous because of your low taxable income. Then, once you begin taking social security you would have money from your ROTH available tax-free.
Having both accounts to choose from give you flexibility during retirement. Have one year where your tax bill will be high? (maybe you get an inheritance, take a large payout etc.) Your ROTH will be there that year to provide you with tax free income, allowing you to avoid potentially high taxes.
Or, having a ROTH and an IRA can help diversify your exposure to future tax increases. It seems inevitable that congress will want more of your money in the future (and we are in a historically low tax rate for investments), so having a ROTH IRA today may help protect you from tax increases tomorrow.
Being able to control where your money comes from, and therefore being able to control your tax burden could be a huge advantage.
Conclusion
Like with many scenarios in today’s investing world, a little diversification may be the answer.
IRAs and ROTH IRAs each have their own advantages and disadvantages, and the same person may be able to take advantage of both accounts at different times during their life.
Knowing and using the differences of these two accounts to your advantage could mean a huge potential tax savings in time of retirement.
Interested in opening a ROTH IRA or IRA, there are a few more rules to know. But no worries, we cover those in our post right here: Comparison of Investment Account Types
