As the end of the year approaches, many Americans may be in a rush to complete year-end financial tasks that will help them to save a little money. One of those tasks include opening an individual retirement account (IRA). However, choosing between a traditional IRA and a Roth IRA remains a tough decision. A traditional IRA allows taxpayers to deduct their contributions, but taxes are imposed when distributions are taken during retirement. Meanwhile, contributions to a Roth IRA are not tax-deductible, but taxes are not imposed on distributions.
Generally, taxpayers who expect their tax rate to increase should go with a Roth IRA while those who expect their tax rate to decrease should opt for a traditional IRA.
The table below compares the differences in retirement savings between a traditional IRA and Roth IRA with a few factors to bear in mind. Assume that the person saving for retirement, we’ll call her Mary, is a single tax filer, starts saving at age 25 to retire at age 65, contributes $5,500 per year and earns an average annual return of 5 percent.
|Current Tax Rate (age 25)||Future Tax Rate (age 65)||Traditional IRA||Roth IRA|
*The amount in () represents the balance accumulated from tax savings that earn an average annual 5 percent return in a taxable account.
If Mary started in a lower tax bracket (15%) and entered a higher tax bracket (28%) at retirement, she would have about $109,000 more in retirement funds by contributing to a Roth IRA instead of a traditional IRA.
The traditional IRA would be the wiser choice if Mary started at the higher tax bracket and fell to a lower one. In this example, the traditional IRA would have led to $28,000 more in her nest egg.
Because many people tend to start off with lower-paying jobs and work their way up to higher-paying positions, it makes sense for these taxpayers to choose the post-tax contribution structure of a Roth IRA, which is often recommended by financial experts.
Regardless of the the type of retirement account you choose, there is still plenty of time to open an IRA and meet the contribution deadline. For tax year 2013, you may contribute a maximum of $5,500 or your annual income, whichever is higher. The deadline to contribute to tax year 2013 is April 15, 2014.