When the subject of Individual Retirement Accounts (IRAs) comes up, the one question that seems to cross everyone’s mind is: Which investment vehicle is better, a Roth IRA or a traditional IRA?

The subtle differences between the two types of IRAs are the source of all the confusion, but the answer depends largely on whether you expect to be in a higher or lower tax bracket when you start to draw funds out in retirement — however, there is actually more to consider than just your tax bracket.

Four important IRA features to consider

For most Get Rich Slowly readers, the four most important considerations are these:

  1. Contribution limits: For Roth IRAs and traditional IRAs, the contribution limits are identical. In 2015, you may contribute a maximum of $5,500 a year to your account. If you are 50 or older, you may contribute an additional $1,000.

  2. Income limits: Both Roth and Traditional IRAs have income limits. (You can get the details on the IRS website: Form 590 for Roth, and Form 590-A for traditional.)

  3. When contributions are taxed: Both types of IRA are tax-advantaged, but in different ways.

    • Traditional IRA — You are usually able to fund a traditional IRA with pre-tax dollars, so you pay taxes when you withdraw the money.
      (If you or your spouse has a retirement plan through an employer, the deductibility of your traditional IRA contributions may be subject to income limits.)

    • Roth IRA — The money you put into a Roth IRA has already been taxed and will grow tax-free; therefore, you are able to withdraw it tax-free.

  1. Annual distributions after age 70 ½: You must take yearly distributions from a traditional IRA (and pay taxes) when you are over 70 ½ years old. There is no such required minimum distribution with a Roth.
Comparing Features: Roth IRA vs. Traditional IRA
Roth IRA Traditional IRA
2015 Contribution Limit – < 50 $5,500 $5,500
2015 Contribution Limit – > 50 $6,500 $6,500
2015 Income Limits IRS Roth IRA Info IRS Traditional IRA Info
Required Annual Distribution None Required at 70.5
When Contribution Is Taxed Before contribution At withdrawal

How to choose between a Roth IRA and a traditional IRA account

So if you qualify for both, which one is best? In general, the rule of thumb is:

  • Choose a Roth IRA if you suspect that your retirement tax rate will be equal to (or greater than) your current tax rate.

  • Choose a traditional IRA if you think your tax rate will decrease during retirement.

Of course, nobody knows what their future tax rate will be. As a general guideline, take an honest look at your lifestyle and your dreams for retirement. If you live a frugal lifestyle, your withdrawals from your IRA should be low enough so as not to put you in a high tax bracket. In that case, a traditional IRA might work best for you.

However, if you are starting early and you know you will have a substantial nest egg which you plan to use to travel the world in style, you can expect to be withdrawing a high enough amount to put you in a higher tax bracket then. If that is the case, a Roth IRA might make more sense for you.

Looking at it from the other side, if you are in a high-paying job now, a traditional IRA might be attractive because you save a significant amount of income tax from the deduction you take. If, however, you are in a low tax bracket at the present, a Roth IRA might make more sense, because you won’t get a significant tax saving from your deduction.

Getting more specific

If you want more explicit information, you should search the web for an IRA retirement calculator. Be aware, though, that your assumptions about the future are just that — assumptions. Nobody knows what tax rates will be like in the future. If you make very little now, you can guess that your tax rate will probably be higher in retirement. If you make a lot, your tax rate could very well be lower. But what about the rest of us?

I asked Dylan Ross of Swan Financial Planning for his advice:

Because many people will have tax deferred savings from other sources anyway, it usually makes sense to go with the Roth when you have the choice.

Most people will not be withdrawing their entire IRA in a single tax year. It’s entirely possible that some years will have higher tax rates than present and some years will be lower. This is why I think it makes sense to try to have tax-free (Roth) and tax-deferred savings, so I can have options in the future. If I want to save some of my tax-free when I’m retired because tax rates are at a low and I suspect will eventually rise, I’ll pull from my traditional IRA. If tax rates are super high, I’ll tap the Roth.

I’m an advocate of diversifying the tax treatment of my retirement savings; but in the end, when you have a choice, putting it all in the Roth is usually the better move.

The question remains, and the answer is personal

Traditional and Roth IRAs are great tools to help the average American save for retirement. There are several subtle differences between the two accounts that affect everyone whether they are just starting out in their retirement planning career (and it is a career, the only one from which no one can ever be fired or laid off) or they happen to be near (or even in) retirement.

So which is better? It depends. Your circumstances determine which account makes the most sense. If the choice is not clear to you, you should probably consult a qualified professional such as an accountant or a certified financial planner. Most of the time I route people to one of my previous articles if they want to get a better handle on the subject:

If you are more interested in 401(k)s than IRAs, the same train of thought applies. (And because you are dealing with an uncertain future, a train of thought is the closest you can hope to get to a firm scenario.)

[Editor's Note: For the month of July, we're going to focus on building wealth. So this week, for Throw-back Thursday, we decided to bring back another of J.D. Roth's great articles in the Roth IRA series. Enjoy!]

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