A Great Debate: Traditional IRA vs. Roth IRA

Choosing between retirement accounts is a decision that affects your financial future, even though it may seem like no one gives much thought to the choice. Understanding the key differences between retirement accounts can be beneficial for making an informed decision and caring for your future self. A Roth IRA (Roth) allows you to contribute after-tax dollars today with the benefit of tax-free withdrawals in retirement. A Traditional IRA (IRA) offers tax-deferred contributions meaning you pay taxes on withdrawals in the future. The advantage of an IRA is that you can go tax-free today. This decision can be made strategically, influenced by your tax bracket, future income expectations, and retirement goals.

For example, there is a postgraduate individual working for a civil engineering firm. The company comes ready to set up a retirement account and asks to choose an IRA or a Roth. Assume that the individual desires to retire at the age of 65 and does not plan on withdrawing distributions from their retirement account until they are officially retired. At that point, their tax bracket drops significantly, because they go from c-suite positions at their civil firm to a lower income. This would make them a good candidate for a Traditional IRA, because they will experience tax advantages in their retirement, even though they will still be paying taxes. The advantage lies in the fact that they are in a lower tax bracket at the age of 65 than when they were in their early 20s just starting their career.

Now, let’s explore a situation where we might choose a Roth IRA. Some people anticipate that pension income, taxable investments, rental income, or part-time work could place them in a higher tax bracket than during their primary earning years. This could be a situation where they might be a good candidate for a Roth IRA. They will pay their taxes up front while they are still in that lower tax bracket. Assuming their income continues to grow into retirement they will then be able to pull from their accounts tax-free.

The interesting news is that Roth conversions are possible, meaning you can convert your Traditional IRA into a Roth IRA. Some people choose to convert a particular year of lower income to a Roth to capitalize on the lower income tax year. Another reason for a conversion could be to maximize your estate for your family. You will pay the taxes up-front, but your heirs will be able to withdraw that money tax-free.

There are many factors to consider when choosing a Roth IRA or a Traditional IRA and it really depends on the trajectory of your life and your goals. It can be empowering to have the financial literacy to make an informed decision. The tricky part about choosing is it can be challenging to anticipate what your life will look like 10 to 40 years from now. All we can do is consider who we want to be and where we want to be, and plan accordingly.