There is much debate on whether a Traditional IRA or a Roth IRA is better for investors. Typically, this can be decided by whether you believe your tax rate is higher now or will be higher in retirement, how long until retirement and how aggressively you are investing. I argue that both are advantageous and the capability of saving in both ways can benefit a retiree. Just as you diversify your investments, diversifying your taxes can lead to more options later.
The major advantage of a Traditional IRA is that contributions are tax deductible if you are in a retirement plan and under certain income limits. The investments inside the IRA are tax deferred. However, in retirement, distributions from the IRA are taxed as income. The downside of this is that it can lead to taxation of social security and your distributions from the IRA will typically need to have tax withholding applied.
On the flip side, contributions to a Roth IRA get no special tax treatment. Contributions are limited to taxpayers under a certain income level. Just like the Traditional IRA, assets inside the Roth grow tax deferred. The big advantage comes on the back end, where qualified distributions from a Roth are tax free. Thus, all the growth inside the account is not taxed.
Income levels in retirement become an issue because social security can become taxable over income levels starting at modified adjusted income of $25,001 for singles and $32,001 for married couples filing jointly. Money distributed from a traditional IRA or 401k is treated as income and counts against you in the calculation. A qualified Roth withdrawal does not count as income and thus can be the difference between owing taxes on social security or not.
The widely accepted ‘4%’ withdrawal rate goes farther when you don’t have to withhold Federal Taxes (in Pennsylvania, retirement withdrawals are not state taxed). In addition, for those who wish not to begin pulling money out of retirement, there is no required minimum distribution for a Roth IRA. The money may stay inside the plan even after 70 ½.
My suggestion is to diversify your taxes by at least placing a minimal portion of your annual contributions into a Roth if you are able. For 2014, you have up until April 15, 2015 to make a contribution to an individual Roth IRA account. Many employer plans now have Roth options if you are unable to do an individual Roth IRA due to income restrictions. This small step may require you to pay more taxes now but it may also help you pay less taxes later.