Since traditional IRAs mean immediate tax savings, it's best to contribute to one if you think your tax rate is higher now than it will be after retirement. Let's say you're eligible for both a Roth account and a traditional IRA. You usually do better in a traditional version if you expect to be in a lower tax bracket when you retire. By deducting your contributions now, you reduce your current tax bill.
When you retire and start withdrawing money, you'll be in a lower tax bracket, which will give the tax collector less money overall. If you expect to be in the same tax bracket or higher when you retire, you may want to consider contributing to a Roth IRA, which allows you to settle your tax bill now and not later. The traditional IRA is one of the best options in the toolbox for saving for retirement. You can open a traditional IRA at a bank or brokerage agency, and the investment universe is open to you.
But that freedom comes with responsibility. Traditional IRAs have many rules: they break one and you could face a penalty. However, follow those rules and you may end up with a lot of changes in the future. A traditional IRA can be a great way to increase your savings by avoiding taxes while you build up your savings.
To get even after-tax savings, you must be disciplined enough to reinvest the traditional IRA tax savings you earn each year in your retirement savings. Unless you're an extremely disciplined saver, you'll end up with more after-tax money in a Roth IRA. Ed Slott, IRA IRA expert, explains the most common IRA mistakes and the missed opportunities you can avoid. If you are going to transfer money from one IRA to another, for example, to change custodian or consolidate accounts, request a direct transfer from one trustee to another.
Most brokerage firms act as custodians of both Roths and traditional IRAs with the same minimums, fees and conditions for each. The classic 401 (k) plan offered by most employers offers the same tax benefits as a traditional IRA. If you own the same shares in an IRA and it pays you dividends, they are not included in your taxable income. Even if you think the market is overvalued, it's usually worth making the maximum contributions to your IRAs.
If you also invest in a Roth IRA, the sister of the traditional tax-free IRA, in which you keep money after taxes in exchange for future tax-free withdrawals, the total amount of money you can contribute to both accounts cannot exceed the annual limit. But the point is, investing in an IRA can help your retirement savings grow faster than they otherwise could. Instead, you can withdraw sums equivalent to your Roth IRA contributions without penalty or taxes at any time and for any reason, even before age 59 and a half. The potential downside is that while traditional IRA contributions may be tax-deductible, withdrawals from a traditional IRA are considered taxable income regardless of the marginal tax rate or tax bracket in effect at that time.
While some workplaces offer a Roth 401 (k) option for employees, if yours doesn't, diverting part of those dollars from those retirement savings to a Roth IRA will give you more options for managing your tax burden during retirement. If you don't qualify to deduct your IRA contributions, you can still accumulate money up to the annual limit in a traditional IRA.