Should You Open an IRA Or a Roth IRA?

An important consideration in selecting an account type is your expected income tax rate upon retirement withdrawals, along with factors like current income level, investment goals and timeline.

Disciplined Roth IRA owners can make additional savings through tax-free withdrawals during retirement. It is, however, crucial that they understand all fees, commissions and minimum opening requirements before opening one.

Taxes

An Individual Retirement Account, or IRA, allows individuals to claim tax breaks when making contributions in any year that they make them. Individuals can open both traditional and Roth IRAs as well as SIMPLE/SEP or self-employed IRAs for themselves or their businesses. An IRA is a great choice for people without access to workplace retirement plans such as 401(k), who want the flexibility of tax-deductible contributions with potential penalty-free withdrawals in certain instances.

At the core of any decision between traditional or Roth accounts lies your expected income tax rate in retirement. Since you may find yourself in a lower bracket then now, taking advantage of any deductions may make sense; otherwise a Roth IRA might make more sense.

Growth

If you can wait until retirement to open an IRA, its value can exponentially grow due to compound interest and dividends that get reinvested every year.

Example: If you invest $5,000 into an IRA and earn an 8% return in year one, that will result in earnings totalling $7,816 which will then be reinvested along with any other earnings from investments or your portfolio.

This cycle continues until retirement when withdrawals can be made without incurring income taxes or penalties. Depending on your anticipated tax bracket in retirement, Roth IRAs could prove more useful than traditional ones; similarly, younger workers who don’t yet know their future tax rate might benefit.

Withdrawals

An IRA allows you to withdraw contributions tax- and penalty-free, although once they’re gone they’re gone permanently – something which could become problematic should an unexpected expense arise and your savings need to be used immediately.

However, your Roth IRA earnings can be withdrawn tax-free upon retirement if you’re willing to wait. To maximize tax efficiency during low income years when tax brackets will likely be lower.

Traditional IRAs require you to begin taking required minimum distributions (RMDs) when you reach age 70.5; any withdrawal prior to this point incurs an early withdrawal penalty of 10% in addition to income taxes; with one exception for people aged 59.5 or over and satisfying the five-year rule.

Penalties

As long as you abide by the withdrawals rules, contributions to both traditional and Roth IRAs can be withdrawn at any time without incurring taxes or penalties; however, your investment earnings may be taxed depending on their source and when they’re withdrawn from an IRA.

Those withdrawing their investment earnings prior to retirement will face a 10 percent penalty tax unless certain requirements are fulfilled, including using it for qualifying higher education expenses, medical bills, unemployment hardship or the purchase of their first home.

Traditional IRAs may make sense for people who anticipate being in lower income tax brackets during retirement; however, because there’s no way of accurately forecasting future tax rates, a Roth may also be worth considering.

Options

IRA accounts offer investors tax breaks for investments that will help them reach their retirement goals more quickly. Investors can use IRA funds to purchase stocks, bonds, certificates of deposit and dividend stock funds which grow their payouts annually for less volatility.

How you decide between Roth or traditional IRAs depends on your projected tax rate in retirement. Though difficult to accurately anticipate, an IRA contribution calculator may give an estimate. If your projected taxes will be higher in retirement than anticipated, traditional IRAs may offer more tax relief with their upfront tax benefits.