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Choosing an IRA: Traditional or ROTH
When contributing to an employer-based retirement plan, many of your choices regarding options for saving are made for you, depending on the plans your employer offers. However, when contributing to an individual retirement account (IRA), the choice of what type of account to use is completely up to you. While this type of choice can be liberating, it can also be confusing. By learning about the unique characteristics of Roth and traditional IRAs, you can be better equipped to see how each will fit with your financial plan.
IRAs: The Basics
An individual retirement account (IRA) is similar to a 401(k) in that both are designed to hold and invest your retirement savings; however, an IRA is an account that you open for yourself through a financial institution, and a 401(k) is a plan opened and sponsored by your employer. As such, an IRA does not have the benefit of an employer match, so the only contributions to an IRA will be made by you, without any kind of employer aid. IRAs are traditionally used by those who don’t have access to an employer-based plan or who want to supplement an employer-based plan with additional retirement savings.
Making the Choice
Unfortunately, there is no hard and fast rule for choosing between a traditional and a Roth IRA. However, considering your own financial characteristics compared with those of both accounts can help you gain a better understanding of which may have the most benefits for you. Consider the following when making your decision:
Because a Roth IRA is taxed when you contribute to it rather than when you withdraw from it, in general a Roth account will be advantageous if you believe your current tax rate is lower than your retirement tax rate will be. This means you can pay the least amount of taxes by having your contributions taxed now rather than your withdrawals taxed at a higher rate in retirement. Of course, the difficult part of this decision is that you can’t know what tax rates will be when you retire, so there’s no guarantee that they will be higher than they currently are. Many people choose a Roth IRA when they are at the lowest end of their income scale, which is why Roth IRAs are more frequently used by younger people.
On the other hand, if you expect that your tax bracket will be lower in retirement than it is now, you will want to use a traditional IRA. This allows you to incur the least amount of taxes by taking taxes on the withdrawals you receive when in a low tax bracket, rather than incurring tax at your current (likely higher) tax rate. Since future tax rates aren’t guaranteed, the safest option may be to contribute to both a Roth and a traditional IRA.
If you are seeking a tax deduction for your retirement savings, a traditional IRA will likely be the best option, as contributions made to Roth IRAs are not tax deductible.
Roth IRAs generally offer more flexibility than traditional IRAs do, as they allow you to withdraw contributions before age 59 ½ without incurring early withdrawal penalties. This can help you to feel more financially secure in case you should need to withdraw funds from your IRA in an emergency. However, only withdrawals of contributions are not penalized; if you withdraw money that you have earned on your investments (earnings) from your Roth IRA, you will be subject to penalties. Keep in mind that withdrawing money from your retirement fund before retirement should always be a last resort, so if you want to keep yourself honest by denying yourself access to your retirement funds, a traditional IRA may be a better option.
Roth IRAs also allow you more control over when you take distributions, rather than traditional IRAs, which require you to take RMDs starting at age 70 ½.
Income and age limits
Since Roth IRAs are subject to income limits, if you have a high income, a traditional IRA may be your only choice. Likewise, since traditional IRAs are subject to an age limit, if you want to continue to contribute to your IRA during your twilight years, you will likely want to choose a Roth IRA.
You’ve already made the most important choice: choosing to save for retirement. Contributing to either a Roth or a traditional IRA will help you build up your retirement savings, and both are excellent options to do so; the most important thing is to be conscious of your own financial situation to help you choose the best tool for you. For additional insight into which type of IRA would be best for you, contact your financial advisor at Safe harbor Fiduciary.