When Do You Want to be Taxed?
Traditional IRAs vs. Roth IRAs vs. Investment Accounts
As an incentive to encourage Americans to save for retirement, Congress established Individual Retirement Accounts (IRAs) and later Roth IRAs. Both types of accounts offer lower taxes over time compared to regular investment accounts in most cases.
IRAs: Tax Me Now or Tax Me Later
Pre-tax money that is contributed to a Traditional IRA up to $6,000/year ($7,000/year if you are over 50 years old) grows tax-deferred, but it is taxed as regular income when it is withdrawn after age 59 ½. Conversely, money contributed to a Roth IRA has already been subjected to regular income tax, but the growth is tax-free if withdrawn after age 59 ½ (see Table). The U.S. tax code subjects IRA types both to limitations depending on your income and your access to other retirement programs (like 401(k)s or pensions), so you should do your homework or consult a tax advisor before setting up an IRA.
Investment Accounts: Tax Me Now AND Tax Me Later
Money placed in a standard investment or brokerage account and invested in stocks, stock funds or similar assets is less tax efficient because it has already been subjected to income tax AND any growth in the value is taxed as a capital gain in the future. Money that is invested in savings accounts, CDs, or bonds is even more harshly treated from a tax standpoint because any growth is taxed at regular income tax rates, which are 10% to 20% higher than capital gains tax rates.
Picking between Traditional and Roth IRAs
Because of the tax advantages, any money that you know is meant for retirement should be put into either a Traditional IRA or a Roth IRA, not a standard, taxable investment account. Whether to choose a Traditional or Roth IRA primarily comes down to whether you believe your tax rate is higher now compared to what it will be when you are withdrawing the money after age 59 ½.
- If you think your tax rate will be lower after you retire, put your money into a Traditional IRA.
- If you think your tax rate will be higher after you retire, put your money into a Roth IRA.
- If you think your tax rate will be the same after you retire, put your money into a Roth IRA, because it has more flexibility than a Traditional IRA.
The Retirement Plan Offered at Your Work May be Even Better!
Alternatively, a 401(k), 403(b) or 457(b) retirement plan that is available through your work will act in most ways like an IRA, with the added benefit of higher annual contribution limits, typically $19,500 ($26,000 if you are over 50 years old).
Bottom Line: IRAs (and similar retirement accounts) offer significant tax savings and should be filled-up each year with any money that is being invested for retirement.