Which would be better – a traditional IRA or a Roth IRA?

If you do not need to save on taxes now, a Roth IRA is your best option.  The reason is the taxation of earnings.  With a traditional IRA, you save on taxes now on the amount you contribute.  But you pay taxes when you take the money out on both the original contributions and the earnings it made over time.

 

With a Roth IRA, you do not save on taxes on the amount you contribute, but you do not pay taxes on the amount you take out on both the contributions and the earnings.  This means that essentially, the earnings in a Roth are tax free.  Tax-free!  Name another instance (available to most people) where the IRS allows that.  If you have a long time horizon – let’s say you’re in your 20s – the benefit of tax free earnings is humongous.

 

Both options have certain stipulations.  In both options, you cannot take money out without penalty until you have reached age 59 ½.  With the Roth, you also cannot take money out until the account has been in existence for five years.

 

Some argue that the traditional is best if you believe you will have a lower tax rate during retirement than you do now, but this really does not take into account the taxation difference on earnings.  An instance where indeed a traditional IRA is best is when you have less than five years to go until retirement, and will need to dip into the money right away.  Otherwise, a Roth will be more advantageous.

 

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