One of the most common questions we get from clients is whether they should invest in a Traditional or a Roth IRA. They both have their advantages but depending on your situation, one might be better than the other as these accounts offer very different tax treatments. If you expect to be in a lower tax bracket once you retire, a Traditional IRA is likely your best bet. Alternatively, if you expect to be in a higher tax bracket come retirement, a Roth IRA may be better.
When should you use a Roth IRA?
First, you must make sure that you are eligible to contribute to a Roth IRA. Whether or not you can contribute to a Roth IRA depends on your income and your tax filing status.
You should invest in a Roth IRA if:
- You expect to be in a higher tax bracket in the future. Since withdrawals are tax free, even though you expect to climb to a higher rung of the income ladder in the future, you won't owe the IRS when you start withdrawing funds.
- You're already contributing to a 401(k) retirement plan and are earning income that falls within the Roth limits.
When should you use a Traditional IRA?
Contributions to a Traditional IRA are tax-deductible. The contributions you make are deducted from your income for tax purposes. In other words, if you make $100,000 this year but add $5,500 to your Traditional IRA throughout the year, you'll be taxed as if you made $94,500 of income that year. Thanks to the tax deduction, if your income taxes are around 40%, you'll be getting a ~$2,200 tax refund after filing your taxes. However, since withdrawals are taxed like income, you'll eventually pay taxes on the withdrawals, but at a lower tax rate in the future if your income is lower at retirement than throughout your working years. Very important: to use the Traditional IRA properly, you need to make sure that your tax bracket is high when you're contributing to it but that your tax bracket is low when you withdraw from it.
You should invest in a Traditional IRA if:
- You expect to be in a zero or very low tax bracket when you retire.
- You don't currently have access to a 401(k) retirement plan so you can take the tax deductions on your contribution.
Pro tip: If you're a high income earner (i.e., making more than the Roth limits) and are also contributing to a 401(k) retirement plan, you can consider a backdoor conversion which involves making non-deductible contributions to a Traditional IRA and subsequently converting the account to a Roth. Book a call with a portfolio manager here to discuss if this strategy may be right for your situation.
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