Roth or Traditional IRA: How to Make the Call

By Carla Fried

It may not have the caché of boxers or briefs, but in retirement circles one of the big questions is whether you should invest in a Roth IRA or a Traditional IRA. And if you happen to work for one of the few companies that offers a Roth 401(k) option you’ve got to face this dilemma of which way to go with your 401(k) as well.

The math is pretty easy if you are young and haven’t yet reached your peak earnings. If you’re not yet in a high tax bracket, there’s not tremendous value in using a Traditional IRA or 401(k). Your contributions do indeed reduce the amount of taxable income you have for the year, but if you’re in a low tax bracket, then that’s not exactly a huge deal. I’d put a vote in for going with the Roth. You forego that upfront tax break on your contribution –all money you pile into a Roth is done with after-tax dollars –but oh what you pick up on the back end of the deal: Every dollar you withdraw from a traditional IRA or 401(k) is taxed at your ordinary income tax rate. Capital gains rates do not apply to IRA and 401(k) investments. But with a Roth you can withdraw every penny tax free in retirement. Free as in zero tax.

Now if you’re already in a high federal tax bracket and/or you’ve got a large state income tax to deal with, a Traditional IRA can still make a ton of sense; reducing your taxable income right now has plenty of value to you. That said, having some retirement income that will be yours to tap free of owing any tax is alluring as well. A popular approach used by many financial advisors these days is to recommend you have both types of retirement accounts. Think of it as tax diversification: you get the benefits of both the Traditional (up front tax break) and the Roth (no tax on withdrawals!). It's also a smart way to hedge your retirement portfolio against whatever may happen to our tax code in the coming years and decades. By having money in both types of retirement accounts you can rest a little easier that you won’t get whipsawed by any unforeseen policy change that impacts your tax bill.