Roth vs. Traditional IRA – Which is Right for You?
Aside from funding your 401K tax advantaged plan at work, individual retirement accounts (IRA) should be used to supplement retirement savings. The question that we often get asked is whether to contribute to a Roth or traditional IRA.
The answer to this question depends on whether you think you will be in a lower or higher tax bracket when you retire than what you are in now. This is difficult to determine since retirement may be many years in the future and you are not sure what the tax laws will be or what tax bracket you will be in. The important thing is to understand how a Roth differs from a traditional IRA.
When you contribute to an IRA, you get the tax advantage up front in the form of a deduction from your income tax (subject to phase outs at certain income levels). The assets in these accounts grow with no capital gains tax. When you are 70 ½ years old, you are required to start taking the funds out of the IRA just like you would need to do with a 401K. At this point, any dollar taken out of your IRA would be taxed at your tax rate at the time that you make the withdrawal.
When you contribute to a Roth IRA the tax advantage is deferred. The money that you put into a Roth is after you have paid taxes. The assets in the account grow tax free. At no time are you required you take the funds out, and when you do take the money out, there is no income tax paid at that time as you have already paid the taxes on this money up front.
Also, the Roth IRA is more flexible if you need to make an early withdraw (before 59 ½). You are able to take out your original contributions without paying a penalty or tax. However, if you take an early withdrawal from an IRA in most situations you will pay a 10% penalty plus income tax.
There are certain income limits that apply to qualify to put money into a Roth, but if you are below those limits and are currently in a lower tax bracket, it makes sense to contribute money to a Roth IRA. This also provides a tax diversification strategy. The 401K and IRA are the same in that income is realized when you take the money out and taxes are paid at that time. So you may think that you will be in a lower tax bracket when you retire, but depending on the size of your retirement plans, pension plans, or other sources of income, your tax bracket may be higher than you think. Alternatively, you will pay no taxes on the Roth and you get to decide when you take it out. And as long as you have income, you can contribute to a Roth IRA. For young people just entering the workforce the Roth IRA is a great option. A combination of a 401K at work and a Roth IRA is a good strategy for your retirement planning.
At Chatham Wealth Management, we advise on all aspects of financial planning as well as managing your investments. Please contact us at www.chathamwealth.com if you would like us to conduct a free portfolio review.