Tax season is the time of year when many people make contributions to Individual Retirement Accounts (IRAs). These accounts can help you save money for later in life and also offer potential tax benefits. You can contribute to a Traditional or Roth IRA for 2017 up until the April 17 tax-filing deadline.
The tax benefits you may qualify for with Traditional and Roth IRAs are different. Learning about these two varieties of IRAs may help you decide which to select if you qualify for both.
Depending on your circumstances, you may be eligible to choose between:
- contributing to a Traditional IRA and deducting your contribution on your tax return, or
- contributing to a Roth IRA and withdrawing your funds tax-free in retirement.
Here is some information to keep in mind if both options are open to you – along with reasons why some people pick one choice or the other.
The fundamental choice: Get a tax benefit now or later
The tax benefits of a deductible Traditional IRA and a Roth IRA are in some ways the mirror image of each other.
If you are eligible to deduct a contribution to a Traditional IRA, your contribution may reduce your federal tax bill. When you take distributions, assuming you had taken a tax deduction on all of your contributions, you will potentially be taxed on all of the money you withdraw.
If you are eligible to contribute to a Roth IRA, your contributions are not tax-deductible, meaning there is no upfront tax benefit. However, distributions after age 59½ generally are tax-free.
Some reasons why people pick a Roth IRA
If you think you’ll be subject to a higher tax rate in retirement than you are now. Perhaps your tax rate is low now (maybe because you’re at the start of your career), and you think you’ll be in a higher tax bracket when you retire. If you’re right about that, it may be to your advantage to withdraw from a Roth IRA on a tax-free basis in retirement compared to deducting your contributions now.
If you already have retirement accounts that will generate taxable income in retirement. If you put pre-tax earnings into a 401(k) plan or make deductible contributions to a Traditional IRA, withdrawals from those accounts in retirement will generally be considered taxable income. In retirement, you might appreciate the flexibility of also having a Roth IRA that you can tap without owing tax.
If your goal is to maximize your IRA contribution. The maximum annual contribution to a Traditional or Roth IRA is technically the same: $5,500 (or $6,500 if you are 50 or older by year-end) for both 2017 and 2018. But effectively you are putting more dollars aside for the future when you contribute $5,500 to a Roth than when you put the same dollars into a deductible Traditional IRA.
The Roth contribution pinches your wallet more: Say you contribute $1,000 of your earnings to an IRA. With a deductible contribution to a Traditional IRA, you don’t pay tax on those earnings now, so you are out of pocket $1,000. With a Roth, you are contributing the $1,000 to an IRA plus paying the tax on the earnings.
The payoff is that in the future a given amount you withdraw as a qualified distribution from a Roth IRA has more spending power than a similar amount you withdraw from a Traditional IRA. If you withdraw $1,000 from a Traditional IRA, you will potentially owe part of that to the IRS, leaving you less to spend. With a qualified distribution of $1,000 from a Roth, you can spend all of those dollars without incurring tax.
Some reasons why people pick a Traditional IRA
If you’re in the prime of your career and expect to be in a lower tax bracket later. If you have reason to believe your taxable income will be lower in retirement than it is now, your effective tax rate may be lower in retirement as well. In that case, the tax benefit you get from deducting a contribution to a Traditional IRA from your taxable income today may be worth more than the value of tax-free withdrawals from a Roth IRA later in life.
If you are unsure which IRA will ultimately be better for you and you’d like to enjoy a tax deduction now. It can be difficult to predict what your income and effective tax rate will be when you retire. You might prefer to contribute to the Traditional IRA if you know you can get a tax benefit today.
You can get started on IRA saving with Honest Dollar
Whether individuals are interested in a Traditional IRA or a Roth IRA, Honest Dollar by Goldman SachsTM offers the ability to contribute on a flexible schedule. Customers can open an account in minutes and get access to model portfolios designed by a team of professionals at Goldman Sachs’ Investment Strategy Group.
Goldman Sachs & Co. LLC (“GS&Co.”) does not provide accounting, tax or legal advice. Nothing communicated to you on this website should be considered tax advice. You should consult an independent tax professional regarding your personal circumstances. This material is provided solely on the basis that it is educational only and will not constitute investment advice. GS&Co. is not a fiduciary with respect to any person or plan by reason of providing the material or content herein.