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 Which is best for your contributions – Traditional or Roth IRA?

Which is best for your contributions – Traditional or Roth IRA?

The holidays are over!  Our New Year’s resolutions have been set and probably already broken.  The cold weather has settled in, and will be with us for the next couple of months.  You know what that means, don’t you?

It means that tax season is also upon us!  The race is on to file your taxes by April 15th. Can you feel the excitement? Probably not, unless you are an accountant or expecting a big refund…

One of the questions that always crops up before filing a tax return is, “Should I contribute to a traditional or a Roth IRA?”  People always want to know which one is better.

As a quick recap, contributions to a traditional IRA typically are tax deductible (if you meet the requirements) and any growth is tax deferred until withdrawal after age 59-½.  If you have a retirement plan at work, you are not eligible to contribute to a traditional IRA unless your income is below the modified adjusted gross income level set by the government.

Contributions to a Roth IRA are not deductible.  Any growth in the Roth IRA account is tax deferred and distributions are tax free as long as you meet the distribution requirements, which begin with a 5-year waiting period.  You can contribute to a Roth IRA if you have a retirement plan at work that does not have a Roth option and as long as your income is less than $129,000 if you are single taxpayer and $204,000 if filing jointly.

For both IRA’s, the maximum IRA contribution in 2022 is $6,000 before you file your taxes.  If you are over 50, you can make an additional contribution of $1,000.  In 2023, the contribution limits are increasing to $6500 with a catch-up contribution of $1000. In addition, there may be a 10% penalty for withdrawals before age 59-½.

If you have the money available and didn’t contribute to retirement plan last year, then it is highly recommended that you contribute to either type of plan.  If you did contribute to a retirement plan at work, then it still would be good idea to consider making an additional contribution into either option, as long as it doesn’t affect your daily obligations or insurance expenses.  Ideally, 10% of your income should go to savings, but reality is often this ideal.

As to which type of IRA is better, the choice is a function of your situation.  Obviously, if you have contributed to a retirement plan at work, then the Roth IRA may be the only choice, assuming your income is below the income threshold.  If you didn’t contribute through your employer, then your current income, the contribution amount and timeframe until retirement are the factors that you need to consider when deciding on which option to choose.

As an example, let’s say a 40-year-old woman is in the 25% tax bracket.  If she contributes $6,000 to a traditional IRA, she will save $1,500 in taxes.  The government is helping us by allowing those tax dollars to grow tax deferred and compound over time.

To contribute a net of $6,000 to a Roth IRA at the 25% tax bracket, this same woman will pay $2,000 in taxes ($8000 X 25% = $2,000).  That is a lot of money that could be used for other purposes!

(Compliance Alert:  These calculations are hypothetical, and are for comparison purposes only.  Investment returns and tax rates will change over time.)

In both cases, if you contribute $6,000 per year for 20 years, you will end up with $233,956 if you average a 6% return.  The funds in the traditional account would be fully taxable when taken out for retirement.  The funds in the Roth account would be tax free when withdrawn.

The difference is, “What would you do with the $2,000 that didn’t go to taxes each year?”  If the after-tax amount of $1,500 per year from the $2000 difference is invested at a net return of 4.32% (a gross return of 6%), that account will be worth approximately $46,200, which can then be used for retirement.

This $1,500 difference may be needed for daily expenses.  It may be needed to pay for life or health insurance.  It could also be used to save for college for your children.

The truth is that neither plan has a true advantage over the other.  Your current situation, goals, income, timeframe and employment are the factors that need to be considered when making this decision.  Where and how you invest your contributions may have an effect on your thinking as well.

If current income went into a higher tax bracket, then how would that affect the decision? Being in a lower tax bracket or only being able to contribute a small amount are important factors as well.

The question is, “How would each IRA fit into my current situation?”  Whatever your accountant or financial advisor advises should definitely be taken into consideration.  However, ultimately, it is your money and you get to decide.

The most important part is that you are setting aside funds for your future.  If you don’t save for the future, how will you live when you want to retire or can’t work any longer?  Do what works best for you!