An individual retirement account (IRA) can be an effective retirement savings tool, but how do you choose between a Roth or traditional IRA?
What's the difference between a traditional and a Roth IRA?
A traditional IRA lets you make contributions on a pre-tax basis (as long as your income is below a certain level) and pay no taxes until you withdraw the money. This makes a traditional IRA a good option for those who expect to be in a lower tax bracket during retirement.
A Roth IRA is good for investors who expect to be in a higher tax bracket during retirement than now. It also offers more flexibility because you can withdraw the money tax free (won't increase your tax bill) and you don't have to take a required minimum distribution (RMD) like you have to with a traditional IRA.
How much can you contribute?
The maximum for 2021 is $6,000 ($7,000 if you're 50 years old or older). If neither you nor your spouse is offered a retirement plan by your employer then there is no income limit for contributing to a traditional IRA and the contribution becomes fully deductible. If either of you participate in a workplace retirement plan, the deductibility phases out.
Roth IRA's on the other hand can only be contributed to if your income meets certain limits. Here is a great chart from Quest Trust Company which we've shared below.
Income eligibility for Roth IRA contributions
Which one should I choose?
If you think your tax bracket will be higher when you retire than it is today you should consider a Roth IRA. This will be especially true for younger individuals who haven't reached their peak earning years. The other advantages of a Roth IRA is that it isn't subject to RMD's and you can withdraw a large amount without impacting your taxes at all. Another reason to consider a Roth IRA is if you think the government is going to raise taxes in the future. It's tough to make such a prediction but it's something to keep in mind.
Both of these accounts are great savings tools and you're already ahead of the game if you're funding either one of these accounts. In short, higher income or higher tax rates in the future make Roth IRA's a great option for most people. Tax laws can change at any time so you need to keep up to date on the correct contribution amounts and income limits - this is where an advisor can help or CPA can help.