The allure of tax-free appreciation of funds sure is tempting isn’t it? That’s what a Roth IRA brings to the table since you contribute post-tax dollars that can grow (or shrink) absolutely tax free.
The allure of a tax deduction and “more” assets to appreciate sure is tempting isn’t it? That’s what a Traditional IRA brings to the table since you deduct your contributions (making them pre-tax) and thus start with more funds.
So which one is better?
That’s difficult to say and for many people the decision isn’t as clear cut as I’ve just made it. If your employer offers a 401(k) and you earn over a certain amount, Traditional IRA contributions are not tax deductible. If you earn too much, a Roth IRA may not even be an option for you. However, let’s say you fall into that middle area and need to make a decision… here’s how I would handle it.
Question 1: Do you have a 401(k) that you contribute to?
If the answer is yes, then I’d go with a Roth IRA from the perspective of tax profile diversification. In a nutshell, tax profile diversification means you shouldn’t have all your retirement funds in tax-free or tax-deferred accounts. You should try to have a mix of both because you don’t know what will happen in the future. 401(k)’s are tax deferred whereas Roth IRAs are tax free, so having both is valuable.
Question 2: Will you be in a higher tax bracket in retirement?
It used to be that the answer is clearly no but now it’s not so clear. Our tax rates are historically low (percentage wise) so it begs to wonder whether or not we should shift our tax burden to today in anticipation of higher rates in the future. If you think your tax rates will be higher in the future, you’d want to pay the tax now. If you think your tax rates will be lower in the future, you’d want to defer the tax until the lower rate. If you have no idea or think they will be the same, you might as well defer the tax because paying the man in 40 years is better than paying the man right this second.
Question 3: There is no question three!
You’re done! Two questions is all it takes to figure out which one is best for you, unfortunately question 2 is a doozy and requires a bit of seeing the future. That’s great if you can see the future, but for those of us who can’t… just guess and you’ll do alright.