Roth IRA or Traditional IRA?

When it comes to preparing for your retirement, it’s essential to choose a plan that suits your present income situation and your future financial goals. Two of the most popular retirement plans are the Roth Individual Retirement Account (IRA) and the Traditional IRA (both also available in most 401k plans). Navigating the nuances between the two can be rather challenging. However, understanding their key differences can help you make a well-informed investment decision.

The most significant difference between these two IRAs is the timing of their tax benefits. With a Traditional IRA, contributions are made with pre-tax dollars, meaning you get a tax break upfront. On the contrary, the Roth IRA is funded with after-tax dollars, but qualified distributions are tax-free in retirement.

Your decision between a Roth IRA and a Traditional IRA should be shaped primarily by your current tax bracket and anticipated financial status in retirement. If you expect to be in a higher tax bracket during retirement than you are currently, a Roth IRA may be the best choice as it offers tax-free withdrawals. If you anticipate being in a lower tax bracket at retirement, investing in a Traditional IRA may allow you to benefit from lower tax rates on future withdrawals.

The sunsetting of the Tax Cuts and Jobs Act (TCJA) poses additional considerations. The TCJA, passed in 2017, lowered individual income tax rates for most people, but these cuts are set to expire after 2025. If the current law isn't extended or replaced, most taxpayers will face a higher tax rate. Therefore, now may be an opportune time to take advantage of the lower tax rates by contributing to a Roth IRA. With today’s low tax rates, you can pay taxes now, at a known rate, and have tax-free withdrawals when you retire, potentially at a much higher tax rate.

However, if you predict your income to decline significantly after 2025, the potential tax increase may not affect you as much, making the up-front tax deduction of a Traditional IRA more attractive.

Before making a decision, consider your financial circumstances, your plans for retirement, and consult with a financial advisor as needed. The appropriateness of a Traditional or Roth IRA depends entirely on your individual situation. This includes factors like income level, future tax rates, and when you plan to retire. It is important to make certain you're making the right decision for your future, so take the time to thoroughly research your options and consult with an expert to ensure your retirement wealth is maximized.

About the author:

Paul Carriere CFP® provides fee-only financial planning and investment management services in Colorado Springs, Co. Carriere Financial Planning serves clients as a fiduciary and never earns a commission of any kind. Paul has over 9 years of experience as a financial advisor in Colorado Springs.