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Roth or Traditional IRA: Make the most of your IRA contribution

July 10, 2015

As we near the tax filing deadline we are also nearing your deadline to contribute to your IRA for the previous year.  That means you have to choose between a Roth or Traditional IRA.  The differences are simple but the impact can be huge.

All IRAs (Individual Retirement Accounts) are designed to shelter the growth of retirement assets from taxes.  The government would not create a program that cut them out of receiving income taxes on these assets altogether so you will pay income tax either before or after the funds grow in the account.  Traditional IRAs are funded with before-tax earnings and taxed as regular income when they are withdrawn in retirement.  Roth IRAs are funded with after-tax income and therefore are not taxed when they are withdrawn.

Finding ways to maximize your savings for retirement that can be invested on a tax differed basis.  The contribution limits for these two accounts are the same.  In the Traditional IRA, you’re investing a portion of the government’s future tax dollars in the account with your own.  Therefore there is less room for your money.  The contributions to a Roth account are after-tax dollars so the Roth allows for more of your money to be invested.

Another important consideration is your ability to remove unknown variables to help you reach your goals.  Often a Roth IRA is more favorable for younger investors because they are able to pay taxes on the income at their current tax rate which they expect to be lower than the rate they will pay in retirement.

Keep in mind is that you are planning for the future and that there are many changes that can occur that you have no control over.  Here you need to take the likelihood of these events into consideration.  Changes in income tax brackets are nearly certain to happen over the life of the account while a complete reversal on the taxable status of Roth IRAs is a much more remote possibility.

Compare your current and projected tax brackets.  If your current tax bracket is higher than you expect it to be during retirement then it may be to your advantage to use the Traditional IRA allows you to put off paying tax on that income until you reach that lower bracket.  If you are expecting to make more during retirement than you currently do the Roth could be to your advantage helping you to avoid paying tax at a higher rate.  This issue does take some guesswork as to what you believe future income tax rates may be.

No matter what your particular situation the most important decision is for you to take advantage of the opportunity you have right now to make your contribution for last year before tax day.  If you wait too long it will be gone for good.