Editor's Note: Whether to switch to a Roth IRA, however, is a personal decision that must be made on a case-by-case basis. What follows are two columns discussing both the advantages and pitfalls of the Roth IRA.
There are two types of IRA's, the Traditional and the Roth IRA. One question you may be asking, "Is a Roth IRA better than a Traditional IRA?" This is a great question and the answer is; it depends.
First of all, a Roth IRA is designed to pay income tax on the deposits at today's rate. The growth compounds tax-free and withdrawals are tax-free at retirement. There are some restrictions, of course, like early withdrawal taxes and penalties similar to most retirement plans withdrawn prior to age 59 ½. But is a Roth beneficial when you have to pay taxes on deposits today?
Well, if your gross tax rate is 25 percent today and if you accumulate a net retirement income that would put you in a higher than 25 percent tax brackets or if you feel the government may raise the tax rates in the future to higher than 25 percent then the Roth IRA would allow you tax free withdrawals instead of paying the higher rate. So a Roth is beneficial to pay a lower tax rate today and avoid a higher tax rate in the future. Also, the Roth IRA can continue to grow tax-free after 70 ½ and provides income-tax-free money to your heirs, unlike the Traditional IRA.
Let's briefly look into the Traditional IRA. Sure the deposits are tax deductible and tax-deferred. Contributing to a Traditional IRA allows a tax-shelter for those looking to lower their tax liability. Your money will grow until the required distribution age limit of 70 ½, at which time withdrawals will be taxable at your current income-tax rate. However, this is a gamble. You are assuming the future tax rates won't increase. If the past has taught us anything, taxes do go up.
Now, there is one thing I ask you to consider when comparing the Traditional to the Roth IRA. How are the tax deductible savings used in the case of the Traditional IRA? For example, you contribute $5,000 into your Traditional IRA which is the maximum amount allowable in of 2008. In 2009, you qualify for a tax deduction; let's base this on 25 percent, which equals a hypothetical $1,250 tax savings. Now, that savings only becomes beneficial if it is re-invested into the IRA during the 2009 tax year so it can have compound growth that out performs the Roth IRA. Yet, if you are maximizing your contributions, you can only deposit $5,000 a year so the Traditional will grow at the same rate as the Roth and the Traditional IRA will have tax consequences upon withdrawal.
From experience with clients, the tax refund isn't likely to make it into the IRA. It's earmarked for debt, vacation or other items on the "to do" list. Yes, there is more money in your pocket to spend from the tax deduction; however the growth within the IRA accounts is going to be the same.
So, what does all this mean? The bottom line is determining when to pay taxes. Yes, Uncle Sam will get his piece of the pie. But remember, you have some say in the matter as to when and how much.
As always, deciding if you are better suited for the Roth IRA compared to the Traditional IRA is something that should be discussed with a licensed professional. There is only one chance to prepare for retirement, make sure you are going about it the best way that protects your family.
Questions regarding your retirement options can be addressed to Lynn Lowey, Primerica Financial Services. 480-363-9483.