Roth IRA vs Traditional IRA
Should you choose a Roth IRA or a traditional IRA? This is a question which so many people often ask, and quite understandably, when you are saving for your retirement it's important to know which of these two options is going to be your best bet.
In fact, there are about eleven different IRA accounts available, but most commonly people need to understand the distinction between a Roth IRA and the traditional IRA accounts so that they can decide which represents the best option for them. Clearly much will depend upon your individual personal circumstances, your income, likely needs financially, your age, and so forth. Let's have a look at the basic differences between these two accounts and see how these differences might impact upon your choice.
In theory, at least, either a traditional IRA or a Roth IRA should still be able to provide you with the same level of return. This is perhaps not necessarily what people want to hear though, since having the same final outcome only begs the questions further - what's the difference then?
One of the key facts to consider is the way that the tax rates work. Bearing in mind the tax rates at the time just before you wish to withdraw your money and just after can make a significant impact on which option is likely to work in your favour.
Perhaps the simplest and best advice in this regard is to follow this simple rule: if you anticipate being in a lower tax bracket financially at the time when you retire than you were when you were making contributions towards your IRA account, then it is most likely going to be the case that the traditional IRA, not the Roth IRA, will be your best options.
The reason for this is because you will effectively be avoiding tax liabilities during the time you are making your contributions, with tax rates higher, but when tax rates fall as your income falls, you'll then be paying tax at this reduced rate. This is because the tax requirements are deferred, but the tax rates are not. So if you pay contributions during this high tax period, you'll be making these payments tax free. When the time comes to pay the tax, you'll only be paying a lower amount compared to the previous rate.
Having said this, a Roth IRA is much more suitable for you compared to the traditional IRA if you are likely to be in a higher tax bracket at the time when you retire compared to when you were actually making contributions towards the account. This is because you are paying taxes at the lower rate for the bulk of the time, and as the rates rise, you're nearing the end of making your contributions in any case.
Since most people anticipate that throughout their career their income will rise, with promotions and career development, this makes the Roth IRA the most suitable option. But of course, individual circumstances and plans will make this a personal choice.
Some people have asked which would be the best Roth IRA account to open if you don't anticipate the tax bracket to change during the course of your career. If you anticipate being on about the same basic income, and will be unlikely to change brackets during your working life then the answer is still a Roth IRA. The basic reason for this is the way in which the Roth IRA shelters your money in a more effective way.
If you are in any doubt, it is almost always the case that if you are eligible to open a Roth IRA then you should do so. If it doesn't perform quite as well as a traditional IRA, or if your circumstances change and you are no longer eligible to continue to make contributions, then it is still a comforting thought to know that you have a good pot of tax free cash to access once you retire in any case.
Of course, it's also worth pointing out that the way tax breaks work for Roth IRA and traditional IRA accounts is quite different. Traditional IRA accounts will deduct the tax, though this is usually deferred. With a Roth IRA, the tax is never deductible, and that includes the interest earned and any withdrawals you make. Having said this, it will be necessary for you to wait until the age of 59 and a half before withdrawing; otherwise, you will incur tax penalties. In addition, there is a stipulation that the Roth IRA has been open for at least five years.
Therefore, with Roth IRA accounts representing tax exempt savings opportunities compared to the tax deferred incentives offered by traditional IRAs, if you're eligible to open one, it's definitely worth pursuing. The next challenge of course will be to examine the different Roth IRA accounts available and identifying which one will suit your personal circumstances and expectations.