This is a question that you may get several different opinions on because it is highly debated, and because everyone is in different positions in their life. Knowing the history and where the country may be going might help you make this difficult decision. Although taxes may be reduced here in the near future, they may not be staying there long. But again, that's another debate. How do you know whether to put money into a Roth IRA, traditional IRA or a taxable account? Let’s go through the advantages and disadvantages of all of them to help you determine where to put your retirement contributions.
First, let’s talk about taxable accounts. Taxable accounts are are funded with after-tax dollars. One advantage of a taxable account is that you have already paid income taxes on the contributions, which is a good thing if you are in a low tax bracket. However, you will continue to pay taxes on interest, dividends and capital gains, which may not be such a great thing in the future if you are trying to reduce your overall taxes in retirement.
Taxes on capital gains can be seen as an advantage since the capital gains rate that you pay on taxes is usually lower than what you would pay on ordinary income taxes. Another thing to think about is when you may need the money. Having the money in a taxable account gives you the ability to have access to it at any point in time without having to worry about the 10% IRS penalty you would incur when withdrawing money from a retirement account prior to age 59.5. That can be another nice advantage over a traditional IRA.
The traditional IRA also has its advantages. A traditional IRA is funded with money that is pre-tax, meaning it has yet to be taxed. When there is a distribution from the IRA, that is when it is taxed at the tax bracket you are currently in. The main advantage of a traditional IRA is that assets grow tax-deferred. The advantage here is that you can defer the taxes today when you might be in a higher tax bracket and then distribute the assets when you are in a lower tax bracket. The traditional IRA works well if you are trying to reduce your overall taxes today when you make a contribution (barring any income limits).
The downside is we don't know what taxes are going to be in the future. This is why it is a highly debatable advantage. If you believe taxes to be at the lowest point today, a taxable account or Roth IRA may be the best solution. If you think you will be in a lower tax bracket in the future, then a traditional IRA may be a better fit. The good news is that if you are having a hard time making a decision today, you can convert IRA money to a Roth IRA later, assuming conversions to Roth IRAs are still around. However, you will have wait until you are 59.5 if you want to avoid the 10% penalty. (For related reading, see: Converting Traditional IRA Savings to a Roth IRA.)
That leaves us with a Roth IRA. Roth IRA money grows tax-free and when it is distributed, it is also tax-free. The downside is you had to pay the taxes upfront to get into the Roth IRA. Because it grows tax-free and when you take it out it's tax-free, in the long run the Roth IRA usually has more advantages. When you retire and you need to withdraw money from your assets, you may be glad you have a Roth IRA because you are taking money out tax-free, which may also reduce other taxes you have to pay on a pension or Social Security. The Roth IRA seems to be the most attractive when thinking about taxes, but keep in mind there are income and contribution limits with a Roth IRA that may make a traditional IRA your only option. (For related reading, see: The Basics of Roth IRA Contribution Rules.)
Which Account Is Right for You?
All these accounts have their advantages and disadvantages, and there is no right answer because everyone’s situation is different. The best thing to do is consider what your scenarios may be to help determine how you may want to contribute to your retirement accounts for the best growth and tax efficiency. A Roth IRA may always be favored, and moving money from a traditional IRA to a Roth IRA has its advantages, but you should do it tactically and strategically. If you can't get over paying the taxes now, the good news is that you can convert the IRA money to a Roth later. You can't do that with taxable accounts unless you have earned income.
The debate about whether to use a taxable account, traditional IRA or Roth IRA will continue. The answer for you may be different than for your neighbor or parents. Someone believing in one scenario doesn’t always make it the best scenario for you. Please keep in mind that you should work with your financial advisor and CPA or tax accountant before taking any of this advice or putting it into action. (For related reading, see: Roth vs. Traditional IRA: Which Is Right for You?)
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