Taxes Now, or Taxes Later
Your best friend says you’d be crazy not to use a Roth IRA. Your Uncle Jack says the smartest investors use Traditional IRAs. And up to this point, you haven’t been able to figure out what is best for you so you haven’t opened either. It’s time to get off the fence and determine which IRA option is best for you. The choice may be clearer than you expect.
Roth IRAs and Traditional IRAs differ in one important way—the government taxes money in a Roth IRA as it goes into the account, and the government taxes money in a Traditional IRA as it comes out of the account. As an investor who is saving for retirement, understanding this difference should be your primary concern when evaluating your IRA choices.
The question you need to ask yourself is, “Am I going to be in a higher tax bracket during retirement than I am now?” If you’re just coming out of school and are just starting your career, chances are good you are in a lower tax bracket than you will be in retirement. If you are well established in your career and only have 10 or 15 years until retirement, your tax-bracket outlook is murkier.
Many people heading for retirement believe they will be in a lower tax bracket than they are now because they won’t be earning as much. While this may be true, you need to be aware of two important caveats. First, if you have all of your retirement savings in 401(k)s and Traditional IRAs, you will have to pay taxes on any money you withdraw. And if you withdraw enough each year to maintain your current standard of living, you may stay in the same tax bracket. Second, the finicky government may choose to raise taxes in the future.
While nobody can predict the future—one of the most frustrating aspects of life—you probably have a descent sense of where your career is going and where you plan to be at retirement. Here’s a rule of thumb you can use when making your decision. If you think you’re going to be in the same, or a lower, tax bracket during retirement, use a Traditional IRA. If you think you’re going to be in a higher tax bracket during retirement, use a Roth IRA.