Should you open a traditional or Roth individual retirement account? Choosing a traditional IRA means you don't pay taxes upfront on your contribution, but you will pay taxes when you withdraw money. If you open a Roth IRA, you pay taxes upfront based on your after-tax income, but then your investments grow tax-free, so you can collect your money later on without having to pay any other taxes on it.
The maximum an individual can currently contribute to an IRA for 2013 is $5,500 (or $6,500 if you are age 50 or older). When choosing between whether to open a traditional or Roth IRA, consider these three factors:
1. Taxes. Theoretically, if your tax rate stays the same as it is now as when you retire, a Roth or traditional IRA would be financially equivalent. However, contributing to a Roth IRA would be a better option if your tax rate increases, while contributing to a traditional IRA would be preferable if your tax rate decreases.
Excluding the likelihood that national tax rates are going to rise as a result of high national debt, there is the added assumption that as you get older, advance your career and earn more money, you will be placed in a higher tax bracket. However, it's also possible that when you retire you may have a lower income and be in a lower tax bracket than you are in now.
It's ultimately a judgment call. Since projecting the future is uncertain, some consumers decide to diversify their tax exposure by contributing to a combination of Roth and traditional IRAs.
2. Early withdrawals. Traditional IRAs charge a 10 percent federal penalty tax on early withdrawals prior to 59.5 years old. Meanwhile, Roth IRAs are more flexible, allowing investors to make withdrawals without getting slapped with a penalty – although earnings on contributions for Roth IRAs are still subject to the 10 percent penalty tax. However, there are some exceptions, such as withdrawing up to $10,000 for first-home purchases or paying post-secondary education expenses.
3. Required minimum distributions. Traditional IRAs require you to begin taking minimum distributions at age 70.5, while Roth IRAs have no required minimum distributions. Since many Americans plan to start living off retirement savings by their 70th birthday, the mandatory withdraw policy on traditional IRAs may not be a deal breaker for a number of consumers. However, if you think you may want to hold off on accessing your savings until you get older, it's something worth taking into consideration.
Income limits. While there are income limits on IRA contributions, a backdoor Roth IRA is an option for consumers of all income brackets. This means you can still have a Roth IRA regardless of your income by contributing to a non-deductible traditional IRA, and then converting that right away to a Roth IRA. The only tax you will have to pay is on increases in value of your investment from the time you make your first contribution to the time when you convert. However, if you make the conversion right away, no taxes should be applied.
Neda Jafarzadeh is a financial analyst with NerdWallet Investing. NerdWallet Investing helps consumers make better financial decisions, such as finding the best Roth IRA account provider for their needs.