By Bo Thornton
When selecting an individual retirement account, the traditional IRA is fine for many of us. However, there are many factors that make a Roth account more compelling, mainly due to tax allocation.
At first glance, it doesn’t seem to make a difference which one you choose if your income tax rate remains unchanged after retirement; however, with a traditional IRA account, your contributions are tax-deferred. After retirement, your withdrawals are taxed as regular income at a rate that, in reality, is likely to change in the future. It’s just the opposite for a Roth IRA account. Roth IRA’s are taxed at a current known rate now, but allowed to grow and be withdrawn later in retirement tax free.
Let’s assume you contribute $1,250 a year for 10 years to either a traditional or Roth IRA. If the balances earn 10 percent a year and the tax rate remains 20 percent, both the traditional and Roth IRAs would end up with $17,531 after taxes. It’s a wash. The traditional account had bigger gains, but the Roth IRA had lower taxes.
If taxes increase, as prices and taxes tend to do over time, the Roth IRA is clearly preferred. If you assume a higher 25 percent tax rate in retirement, the traditional account gets hit with almost $1,100 more in taxes that reduces the balance to $16,436. The amount in the Roth IRA remains unchanged.
Conversely, if your ordinary income tax rate is lower in retirement, the traditional IRA is better. Few see the government lowering tax rates in the future, but keep in mind that your income and tax rate would likely decline in retirement due to the fact that you’d no longer be earning wages.
Tax liability alone isn’t the only argument in favor of a Roth. Other factors in favor of Roth IRAs include:
— no required minimum distribution rule for the Roth IRA. With a traditional IRA, you have to start withdrawing funds at age 70 1/2. Given your tax situation, you may want to delay tapping into your IRA.
— Funds contributed to your Roth IRA may be withdrawn at any time, for any reason, with no tax penalty. Note that this only applies to annual contributions and not the earnings on the funds. This gives you access to your contributions as a sort of an emergency fund. Remember, however, early withdrawals could work against your long-term goals.
— Since there’s never a tax on withdrawals, because you pay the taxes up front. The amount of money you have in your Roth IRA is passed on in full to your beneficiaries. However In certain cases, estate taxes could still apply.
In the end, both the traditional and Roth IRAs offer very distinct tax benefits, but make sure to carefully consider and weigh both options to determine which would work best for your situation.