Retirement accounts are an essential component of life planning, but many people don’t understand them. This is largely due to the overly complex rules and regulations governing contributions and withdrawals from Roth IRA and Traditional IRA earnings.
In fact, the code is so complex that millions of dollars are spent each year enforcing and reviewing these two retirement accounts so the government can get a few thousand dollars in extra tax. If you cut through the nonsense though, the basics are really quite simple.
The Roth IRA allows you to make deposits with after tax dollars, so any earnings your investments make can be withdrawn tax free at a later date. Funds are also more portable, and not subject to as many restrictions.
A Traditional IRA is funded by pretax dollars, meaning that any money placed in the account has not yet been taxed. This means that funds and earnings will be taxed when they are withdrawn, at a later date. There are a number of other restrictions associated with this account as well.
Smart investors will have a both types of retirement accounts at least at some point in their lives. This is because as life circumstances change, so do tax rates. A new family might have deductions for children and house payments, with a lower total income due to being relatively new to the workforce. This would put them in a lower tax bracket, making the Roth IRA account a more attractive retirement option.
In 20 years, that same family may no longer have a house payment or children they can claim as tax deductions. Their total income is also more likely to have increased, and with it their tax bracket. In this case, a Traditional IRA account would make more sense, as their retirement income is likely to be less, resulting in less tax when they withdraw these funds.
Having two accounts has the added benefit of also allowing funds to be withdrawn from whichever is more favorable at that time.
Whichever account type you are considering, make sure to consult with a qualified financial adviser before deciding. Financial consultations are usually tax deductible, and the benefits can significantly improve your retirement outlook.