As a Financial Planner, I often get asked if people should save money in a Regular IRA or a Roth IRA. In a Regular IRA, we contribute money on a pre-tax basis (i.e. we do not pay taxes on our IRA contributions), we let it grow tax-deferred, and we pay taxes when we withdraw the money in retirement. In a Roth IRA, we contribute after-tax money, we let it grow tax-free and we pay no taxes when we withdraw the money in retirement.
That last point (“we pay no taxes when we withdraw the money in retirement”) is of course the one that gets our attention. We don’t like paying taxes, and the thought that we could have tax free income in retirement is really motivating, so much so, that, sometimes, it can be the only thing we focus on.
However the IRA story is not quite that straightforward.
The reality is that we WILL pay taxes whether it is for a Roth IRA or a Regular IRA. With a Regular IRA, we pay taxes when we withdraw the money. With a Roth IRA, we pay taxes before we contribute the money. At the risk of disappointing many readers, allow me to repeat: the Roth IRA is NOT tax-free.
When you do the math you will find that if you 1) invest in the same way in a Roth IRA and a Regular IRA, and 2) are taxed at the same rate on your Roth IRA contribution today, as on your Regular IRA withdrawals at retirement, you will end up with the exact same amount of money to spend in retirement. Call us: we will show you the math.
So which one is best? The answer is that it depends.
In general it makes sense to invest through a Roth IRA when we think that our tax rate in retirement will be equal to or higher than our current tax rate. If we think that our tax rate in retirement will be lower than our current tax rate it makes better sense to invest through a Regular IRA.
How then should you decide?
It depends on your situation.
For instance, if you are at the peak of your earnings, and you can calculate that your income in retirement will be significantly less than it is today, investing in a regular IRA will save you tax money immediately. Since you expect to be in a lower tax bracket at retirement, you will end up paying less taxes.
If you are currently a low earner, and expect to have higher income in retirement than you have now, contributing to a Roth IRA will cost you relatively little taxes, and you will not pay any more when you retire.
Because there are many phases in our working life, there are times when it makes better sense to invest through a Roth IRA or Roth 401(k), and other times when it makes better sense to invest through a Regular IRA or a Regular 401(k). Conversely, there will be times in our retired life when it will make better sense to withdraw from a Roth IRA, and others when it will make better sense to withdraw from a Regular IRA.
It is about balance and careful financial planning. In the right circumstances, the proper balance between Roth and Regular IRAs could save you a significant tax bill. In my opinion, it justifies a consultation with a professional financial planner.