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Roth IRA or Traditional IRA: It Depends on You

The decision about whether to open a Roth individual retirement account (IRA) or a traditional IRA account is unique to each individual. Everyone’s situation and financial circumstances are different, therefore there aren’t any cookie cutter solutions. The decision begins with understanding the differences between Roth IRAs and traditional IRAs, and when it makes sense to contribute to one or the other.

Why Contributing to a Roth IRA Early in Your Career Makes Sense

As shown in the chart above, Roth IRA contributions are made after taxes, so they grow tax-free. The benefits of this tax-free growth are enormous, especially if you expect to be in a higher tax bracket in retirement. Young professionals should consider a Roth because they’re likely not close to their peak earning years and are paying lower taxes than they will be late in their careers and in retirement. If you can pay taxes now, at a lower tax bracket, there’s the potential for tremendous savings when you go to make withdrawals 30-40 years from now.

Another reason to start a Roth IRA early is the income limit. Once you pass $135,000 or $199,000 in income if you are single or married, respectively, you’re no longer able to legally contribute directly to a Roth IRA. There are some workarounds to this rule, however. 

Working Around the Income Limit

First, find out if your employer offers a Roth 401(k). Most employer retirement plans have added a Roth provision, and there are no income limits associated with being able to contribute to a Roth 401(k). If you leave your employer, the Roth portion of the 401(k) can simply be rolled into your Roth IRA.

Second, if you don’t have access to a Roth 401(k), you can consider a backdoor Roth. The backdoor Roth strategy involves making a contribution to an IRA, then completing a conversion to a Roth. (For related reading, see: Too Rich for a Roth? Do This.)

Lastly, the Roth IRA contributions can always be taken out tax- and penalty-free. Since taxes have already been paid on your contributions the government doesn’t penalize you for taking them out. However, it’s typically not a good idea to withdraw funds from a Roth if you have designated them as a long-term investment towards retirement.

Benefits of a Traditional IRA Account

Traditional IRAs are pre-tax accounts. This means when you contribute funds to an IRA, they aren't counted as part of your income for that year. If you made $100,000 one year and made a contribution to an IRA of $5,000, then you’re only paying taxes on 95,000 (excluding other deductions and credits). The flip-side is you’ll eventually have to pay ordinary income tax on withdrawals and distributions in the future.

The benefit of a traditional IRA is you are reducing taxable income in the year you make contributions, thereby freeing up those tax savings to put to work elsewhere. The time value of money says a dollar today is worth more than a dollar in the future, so it may benefit you to save money on taxes today rather than after you retire. It all depends on if you anticipate being in a lower tax bracket in retirement. If you’re currently in one of the top three tax brackets, you’ll save a lot more in taxes today than if you are in the bottom three. Traditional IRA contributions will benefit you most today if you are in a high tax bracket and are looking to reduce your taxable income.

Deciding Which One Is Right for You and Getting Started

Once you understand the differences between the two types of IRAs, you need to think about your own situation and decide which one is right for you. You can’t max out a Roth IRA and a traditional IRA, so you'll have to choose one or the other. Both have a contribution limit of $5,500 a year in 2018. However, if you are married, you can also make a spousal contribution to either type of IRA in your spouse’s name.

Maximizing your retirement contributions through IRAs is a great way to ensure your future self is taken care of. The best way to begin contributing to an IRA is similar to how you contribute to a 401(k) plan. You can set up automatic contributions for the day of you get paid. Even a small amount, say $200 every two weeks, adds up to roughly $4,800 in annual contributions. These small contributions will utilize the power of compounding, and before you know it, you will have accumulated another source of retirement income outside your employer-sponsored retirement plan.

(For related reading, see: Traditional and Roth IRAs: Which Is Better for Taxes.)