Question: How can I determine which IRA is best for me?
People often wonder what type of IRA is best. Both the Traditional and Roth IRAs have significant tax advantages, but in some situations one may be better than the other. Since we can't predict what taxes will be like 20 years from now, if you have the ability to contribute to both types of IRAs, that might be a good idea. By diversifying your tax liabilities, you can be prepared for any significant changes in tax rates by the time you reach retirement.
The benefit of a Traditional IRA is that the contributions you make can be tax-deductible in the year that you make the contribution. That means if you make a $4,000 contribution into a Traditional IRA this year, you can reduce your current taxable income by $4,000. For individuals who are in a higher tax bracket, this can be a reasonable savings.
Since the contributions are done on a pre-tax basis, that means you will be taxed in the future when you withdraw money from the IRA. This money is then taxed as ordinary income. If you expect to be in a lower tax bracket when you retire, this means you see the greatest tax benefits from a Traditional IRA. Keep in mind that you must begin taking required minimum distributions at age 70 ½.
You can think of a Roth IRA as the opposite of a Traditional IRA in terms of taxation. With a Roth IRA, your contributions are made on an after-tax basis, which means there is no current tax benefit to you when you make a contribution. Unlike a Traditional IRA, you can make qualified distributions from the Roth IRA tax free. This typically benefits those who expect to be in a higher tax bracket upon retirement.
Additionally, Roth IRAs do not require that you take required distributions upon reaching age 70 ½. This can be increasingly important as people are living and working longer. Also keep in mind that there are income limitations that may prohibit higher income individuals to participate in a Roth. These income limits are slated to be lifted in the year 2010.