Tax issues prove vexing
There are a couple of different tax issues involved in making the decision between a Roth and traditional IRA. The first is whether you qualify for a tax deduction on a traditional IRA.
If you qualify, the tax deduction for a traditional IRA reduces taxable income in the relevant tax year. If you don't make a lot of money and want to reduce your taxable income, it might make sense to choose the traditional IRA.
"If maximizing your cash flow right now is really important, you might want to go with the traditional IRA to get that deduction," says Featherngill. On the other hand, if you can live without the deduction and qualify for a Roth IRA, it will pay off when you are in retirement and can take tax-free distributions.
You need to consider whether you might be in a higher or lower tax bracket in retirement than you are now. You may assume that your tax bracket will be lower in retirement, but that isn't always the case.
"Nobody who is in the financial advisory business expects income taxes to be reduced in the future in terms of the overall rate. In fact, they are more likely to rise," says Mike Saghy, senior vice president and portfolio manager at FNB Wealth Management in Pittsburgh.
So you have to think about what income you'll have from Social Security, a pension plan and retirement plan distributions, and what deductions you might have to offset that income.
"If you think you're going to be in a higher income tax bracket when you retire than you are now, you'd be better off making a contribution to a Roth than a traditional IRA," says George Wells, president of Legacy of America, a wealth management firm. "If you think you're going to be in a lower tax bracket once you are retired, it's to your advantage to do the traditional IRA."
Overall retirement savings and goals
Other considerations are the current state of your retirement savings, how much you think you're going to be able to save and what types of savings you have.
If you have money in a traditional IRA and have a retirement plan at work, those sources of income will be taxed in retirement at ordinary rates, leaving you with less income from the distributions from those plans, says Charles Cohn, a financial adviser with AXA Advisors in New York.
If you haven't saved a lot for retirement, you should consider a traditional IRA if that makes the difference between contributing or not contributing at all, says Wells. If you're able to do without the deduction, contributing to a Roth makes sense because your contributions will go farther in retirement on a tax-free basis, says Featherngill.
If you have amassed a good-size nest egg and hope to leave money to your heirs, contributing to a Roth IRA versus a traditional IRA would be better, says Cohn.
Roth IRAs are an excellent estate-planning tool because designated beneficiaries can spread out the required distributions they must take from an inherited Roth IRA throughout their lifetime, says Cohn.
As such, passing on a Roth IRA to your heirs is a powerful gift, because inherited funds can grow over a long period of time.
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