Whenever a conversation comes up about retirement accounts, the most common question I get is which is better, an IRA or a Roth IRA? Although the answer depends on your specific situation, my general opinion is that tax-tree (Roth IRA) is always better than taxable (IRA).
The primary difference between an IRA and a Roth IRA is no taxes are paid on the contributions made to an IRA, but the distributions are taxable. With a Roth IRA, taxes are paid on the initial contribution, but not on any of the distributions. I often refer to it as the difference between paying taxes on the harvest (IRA) or paying taxes on the seed (Roth IRA).
Here is an example. Let’s suppose that an investor has accumulated $100,000 in an IRA and $100,000 in a Roth IRA. Let’s also assume that the goal is to grow both accounts to $200,000. Here are the facts. First, there has been no tax paid on the IRA (there are limited exceptions to this) but the tax has been paid on the Roth IRA. Second, when a distribution is taken from the IRA, every dollar will be taxable, whereas when a distribution is taken from the Roth IRA, every dollar will be tax-free. This gives you incredible flexibility during retirement.
The investor can choose to pay the tax on the initial $100,000 (Roth IRA) or wait until it grows to $200,000 and then pay the tax (IRA). In most circumstances, it makes sense to pay the tax on the smaller amount by establishing a Roth IRA. As is common in the financial world, however, there are a few exceptions that may make the opposite true.
For starters, Roth IRAs have an income qualification. For single filers, their taxable income must be $116,000 (2009) or less. For married filers, the taxable income must be $169,000 (2009) or less. If their income exceeds these limits, then contributing to a Roth IRA is not an option.
Second, if someone is in a high tax bracket now but expects to be in a lower tax bracket during retirement, it may make sense to take an immediate deduction by establishing a traditional IRA. However, there is a lot to consider before making a final decision and the calculations can be complex.
As always, this information is not meant to be relied upon as specific advice for your situation since there are many possibilities that cannot be covered in such a short article. I highly advise you to discuss it with your financial planner before deciding which option is best for you.
If you have a specific situation you need to learn more about, please feel free to contact us.
