Trying to decide between using a Traditional IRA or a ROTH IRA? This can be the cause of a lot of debate and has caused more than a few arguments. Traditional wisdom has always said that if you are young or not earning a lot of money at the moment then you should use a ROTH to take advantage of your current low tax bracket, this is assuming that you will be in higher tax bracket when you begin taking withdrawals from the ROTH. On the flip side if you are in a high tax bracket then a traditional IRA might be better because you benefit from realizing the tax break now and hoping that you are in a lower tax bracket in retirement. For the most part this still makes sense and is sound advice for most people, however those of us aspiring to early retirement may need to look at it from a different perspective. First let’s explain the Pros and Cons of each account.
The Traditional IRA – An Individual Retirement Account is designed for anyone that wants to make post tax contributions but have those contributions deducted from their taxable income. An IRA is an account you set up at any brokerage you decide upon and invest in any type of investments you want. Currently an individual can contribute up to $5,500 per year and up to $6,500 per year if over 50, this is considered a catch up contribution amount. The contributions go in tax free and grow tax free, this is advantageous as it allows higher income earners to defer the taxes and let the money compound over time tax free. Withdrawals can be made penalty free after the age of 59 and a half, withdrawals can be made earlier than that but there will be a 10% early withdrawal fee plus taxes that are due, DON’T take early withdrawals……. In general it is best to hold index funds and stick to an investment portfolio you feel comfortable with for the long run.
The ROTH IRA – The ROTH IRA is an account that allows an individual to contribute post tax money but the money will grow tax free and withdrawals will not be taxed either. So after 20-years of compounded interest if you have a million dollars you actually have a million dollars and owe zero taxes on it. Usually a ROTH account is best for someone young or not earning a large salary yet as they will not be in a high tax bracket and could expect to be in a higher bracket later in life. The ROTH has the same annual contribution limits of $5,500 and $6,500 for someone over the age of 50. I personally love the ROTH because it gives you a lot more flexibility in retirement to choose when you take contributions, this has major benefits as you can better control your income which allows you to stay within a certain tax bracket. Let’s say for instance you want to lower your taxable income for some reason, the ROTH has no required/mandatory withdrawals so you could take out as little as you want to offset other sources of income. You could also use a ROTH to bridge the gap between early retirement and age 59.5 when you can begin taking penalty free withdrawals from a 401K or IRA. Another huge benefit is that since you technically never have to withdraw the money a ROTH account makes a great inheritance vehicle, especially since heirs won’t owe any taxes on the withdrawals either. A ROTH could be the perfect place to park a little money to help cover all the cost of hard/physical assets that will be passed on to loved ones.
In closing I don’t think it is necessarily an either or scenario but a how much to allocate to which account. If you are a high earner I think you should put the majority in the traditional IRA and maybe $500 a year into the ROTH, if you have a 401K then max that bad boy out and put any other extra funds into a ROTH. If you have children and they have earned income, mowing yards, dog walking, baby sitting, etc…. start them a ROTH and help them to become Financially Independent a decade or two earlier than you did.