How To Know Which IRA Is Right For You

An IRA (individual retirement account) is an IRA, right? Wrong. Not all IRAs are created equal. Let's examine both in more detail.

Traditional IRA

A traditional IRA contribution is tax-deductible on your federal tax return for the year you make the contribution. 

How does the saying go? The only things you can’t escape are death and taxes. There are tax considerations for a traditional IRA even though the money you put into it isn’t taxed when you put them in.

You pay the taxes you pay on the traditional IRA money when you take the money out at retirement time. When you make a withdrawal it is taxed at your ordinary income rate.

The benefit to contributing to a traditional IRA is that it lowers your taxable income during the year you contribute which lowers your adjusted gross income. Conversely, when you take out the money in retirement you are most likely to be in a lower tax bracket because you are in retirement. For this reason, a traditional IRA is beneficial. However, this supposes that taxes will remain the same or not go up substantially in the future.

While traditional IRAs can be invested in many assets, there are some limits to the types of assets a traditional IRA can hold. This is true in the case of a 401K which from a tax perspective works in the same way as a traditional IRA.

Roth IRA

If a traditional IRA is taxed at the time of withdrawal, you may be able to guess how a Roth IRA is different.

A Roth IRA contributions provide no tax breaks when you put money into it, but withdrawals from it are generally tax-free.

Roth IRAs can be invested in any type of vehicle you want: index funds, lifecycle funds, individual stocks or alternative investments. There are income limits for Roth IRAs.

Which IRA is right for me?

Knowing which IRA is the best choice for you depends on your anticipated income at retirement. If you find that you are eligible for both Roth and Traditional IRAs, you are generally better off with a traditional IRA if you anticipate being in a lower tax bracket than your current tax rate when you retire. However, since it is impossible to predict what the rate of taxes will be in the future a Roth IRA can be substantially beneficial.

Withdrawal Rules

One major difference between Traditional and Roth IRAs is the age at which you withdraw funds.

Traditional IRAs require you to take a required minimum distribution (also known as a RMD) at 70.5 years old whether you need the money or not. Roth IRAs, on the other hand, do not have this age requirement. In fact, no withdrawals are required during the owner’s lifetime.

Roth IRAs become a great vehicle to transfer wealth because if you have another source of income, you can designate it to beneficiaries. Your beneficiaries also receive the income tax-free withdrawals although there may be estate tax considerations.

IRAs were created as an incentive to help you not only save on taxes but also as a way to save for your future. IRAs can be excellent tools to use not only for retirement planning purposes but also during your estate planning process.