Once you determine which types of IRA contributions you’re eligible for, how do you decide which is appropriate for you? Here are some general guidelines if you’re eligible to contribute to a Roth IRA and also to make tax-deductible contributions to a traditional IRA.

For information and help specific to your situation, consult a tax advisor or financial services professional.

If you’re eligible for a Roth IRA and also to make tax-deductible contributions to a traditional IRA

Your decision basically comes down to whether you’ll be better off getting an up-front tax deduction with a traditional IRA, or waiting for the payoff of the tax-free accumulation of a Roth IRA.

Assuming you would contribute the same amount to either type of IRA, your decision depends on what you would do with the money you save in taxes if you make tax-deductible contributions to a traditional IRA. Would you set the annual tax savings aside each year and invest it for retirement? Or would you spend the savings?

For example, if you contribute $4,000 to a traditional IRA and you’re in the 25% federal income tax bracket, your annual tax bill would be reduced by $1,000. Would you actually take this amount each year from any tax refund you receive or from your savings, invest it in a taxable account, and maintain it there for retirement? Or would you spend it?

If you would not invest the tax savings

If you would not invest the savings from your traditional IRA contributions, you’ll have more after taxes at retirement with a Roth IRA. That’s because you spent the tax savings, so it’s not available to add to your traditional IRA as part of your retirement fund.

If you contribute to a Roth IRA rather than making tax-deductible contributions to a traditional IRA, you’ll be giving up a tax break today. But the payoff is a larger retirement fund down the road.

If you would invest the savings from your traditional IRA contributions, your decision depends on whether you think your tax bracket in retirement will increase, stay the same, fall slightly, or significantly decrease.

If you would invest the tax savings and you project that your income tax bracket in retirement will significantly decrease

In this case, you’ll generally have more after taxes at retirement if you contribute to a traditional IRA. The reason the traditional IRA comes out ahead of the Roth IRA: You’re sheltering your current income from a higher tax rate now and making withdrawals later at a lower tax rate.

This is just a general guideline, however. If you’re three or four decades from retiring, the value of a Roth IRA may end up close to a traditional IRA – or even a bit ahead.

Moreover, predicting your tax bracket so far into the future is pure guesswork. So, even if you think your tax bracket will decrease in retirement, your actual tax rate may not if taxes in general increase from today’s rates or if you build an adequate retirement fund.

The bottom line: If retirement is far off, you may consider opting for a Roth IRA to take advantage of its tax-free earnings and more flexible withdrawal rules.

If you would invest the tax savings and you project that your income tax bracket in retirement will stay about the same, fall only slightly, or increase

In this case you’ll have more after taxes at retirement if you contribute to a Roth IRA. The key reason a Roth IRA wins out: because even if you would contribute the same amount to a traditional IRA as you would to a Roth IRA, you’re effectively saving a larger amount with a Roth IRA.

That’s because Roth IRA contributions are made up of after-tax dollars. Therefore, the full amount of your contributions compound tax free and are available for your retirement. In contrast, tax-deductible traditional IRA contributions will be taxed when you make withdrawals, shrinking the amount you actually have to spend in retirement.

Article is for educational purposes only and is not intended to provide specific tax or legal advice. For answers to tax questions, please see your tax professional. For legal questions, consult an attorney.

Previous Step

Privacy Practices Security Practices Business Continuity Plan Supported Browsers Report a Site Problem Linking To Third Parties
©1997-2010 CUNA Mutual Group.