How To Choose Between A Roth IRA Or A Traditional IRA

There is no absolute right or wrong answer to choose between a Roth IRA and a Traditional IRA. But there are some things you should think about that may alter your decision from one year to the next.

Bear in mind that the same tax rules apply to traditional and Roth 401ks as well as IRAs. By way of reminder, contributions to a traditional plan are deductible in the year of the contribution (reducing your current year tax) and withdrawals during retirement are taxed at your then current tax rate for all other taxes deferred. Contributions to a Roth plan are not tax deductible, but the withdrawals are never taxed if held until retirement.

The guiding principle is that you want to avoid the bigger tax. If you think your tax rate this year is larger than your tax rate in retirement, you’ll want to contribute to the traditional plan. On the other hand, if you consider you’ll have a higher rate in retirement than you will this year, you’ll want to contribute to the Roth plan.

As a general rule, you’ll want to contribute to the traditional plans in years where you pay an unusually high tax rate (say, you get a big bonus or exercise stock options). You’ll want to contribute to the Roth plans for years, you have an unusually low tax rate (business losses, the gap in employment, etc.).

For many years, however, there will be no unique tax situation. By splitting your contributions between the two plans, you’ll create some flexibility during retirement. By using some money from the Roth each year in retirement, you may be able to effectively reduce the tax rate on the money you have an obligation to withdraw from the traditional IRA.

Of course, some people believe that the national debt will force future tax rates to be much higher than current rates. If you expect to have the same taxable income in retirement that you have now, it would be a great idea to invest in the Roth IRA as a hedge against those potentially higher tax rates.

On the other hand, while tax rates are likely to be somewhat higher in the future, most people won’t save enough to have the same income in retirement that they have during their working years. You may be in that situation. Your retirement income could leave you in a lower tax bracket than you’re in today—even if tax rates in general are higher.

For instance, many people today are located in the 28 percent tax bracket; numerous are also taxed in the 15 percent tax bracket. Even if those brackets move from 28 and 15 to 31 and 18 percent respectively, if your income drops you to the lower tax bracket in retirement, you’ll have been better off contributing to the traditional plan and getting the 28% deductions all those years and then paying the 18% tax.

In conclusion, you need to assess your situation each year to see if there is a reality or circumstance that dictates a switch from your overall strategy. If outcomes you are unclear, the safest bet is tantamount to split your contributions between the two plans.