DID YOU KNOW… “IRA” stands for “Individual Retirement Account”?
That might appear to be a nonsensical question, but many of us have become so used to saying the word “IRA” that we don’t often remember it’s an acronym made up of three words – “Retirement” being the most important.
Retirement is something that happens in the future, which is where we need to focus our attention when making the decision about what type of IRA in which to invest. Which will work best for us in 20… 30… 40 or more years from now? Which type of investment will provide the most income with the best tax benefits? These are difficult questions to answer (unless you’re one of those rare individuals who can forecast the future), but there are shrewd and logical ways to invest now so that you can have more peace of mind when retirement time arrives.
First and Foremost – the 401(K)
Yes, we’re supposed to be talking about a Traditional IRA versus a ROTH IRA, but it’s crucial to remember that if your company offers to match your 401(K) contribution, that is where your contribution priority should exist. Otherwise, you’re turning away free money. This doesn’t mean that all of your available investment capital should go into your 401(K), but try to contribute enough so that you’re receiving the maximum match by your employer. Once that’s taken care of, there’s the decision of…
Traditional IRA or ROTH IRA?
Before knowing what type of IRA works best for you, it’s important to know the difference between the two.
A Traditional IRA is an account that holds a variety of investments (i.e. stocks, bonds, mutual funds, etc.) and grows over time tax-free. This tax “deferment” means that earnings such as interest, dividends and capital gains don’t get taxed until you take distributions (withdrawals). You can also use your Traditional IRA contributions as a tax deduction.
In a ROTH IRA, the contributions come out of taxable income. A ROTH is an account that also holds a variety of investments, however, you pay taxes upfront (at your current tax rate) and do not pay taxes when it comes time to withdraw those funds. Note: a ROTH IRA cannot be used as a tax deduction.
There are a number of factors that an investor can use to determine which type of IRA is best for them.
- Current Tax Bracket. If your current tax bracket is high, most likely your tax bracket during retirement will be lower (not always the case, but very likely). This means that in order to maximize your investments, a Traditional IRA could be the best bet. That’s because you can get tax deductions on the contributions you make today and pay a lower tax rate on post-retirement withdrawals because you’ll be in a lower tax bracket.
- Future Tax Bracket. If you expect your tax rate at retirement to be higher than it is today, a ROTH IRA might be more advantageous since the total tax that you can avoid in retirement will probably be more than the income tax paid on the present contribution amount. Using this train of thought, younger and lower-income workers can benefit the most from a ROTH IRA.
- Contribution Limits. With a ROTH IRA you can contribute for as long as you’d like (more money for heirs). With a Traditional IRA no contributions are allowed starting in the year you turn 70 ½ and any time thereafter.
- Required Minimum Distribution (RMD). ROTH IRA owners are not subject to RMD. Traditional IRA owners must begin taking RMDs starting on April 1 of the year following the year they turn 70 ½. In both cases, beneficiaries are subject to RMD rules.
Do you have to choose one or the other?
In a perfect world, the answer would be “no”. The optimal strategy would be to invest in both a Traditional IRA and ROTH IRA since each type has its own unique benefits. Unfortunately, many of us lack the finances to contribute to a multitude of investment vehicles and must make a choice determined by our current (and future) individual monetary needs.
So, if presently, you don’t have the income to invest in both a Traditional and ROTH IRA, take the considerations listed above and make the choice that you feel will best suit you now and down the line. If you find that later on you have additional money to use for investment purposes, you can always open the other type of account – both Traditional and ROTH IRAs will be around for a long time to come.