There are lots of facets to consider when deciding whether to contribute to a traditional or Roth retirement account. The truth is that you’ll never be 100% certain you made an optimal choice for yourself. A decision you make today can and should alter how you manage your accounts later, in retirement, but there’s no guarantee using one or the other will lead to an overall lower tax bill.
That said, investors should still take advantage of one or the other tax-advantaged account. And there’s one big thing working heavily in favor of traditional IRAs.
When you contribute to a Roth IRA, you pay taxes on the funds that year. You’re locking in that tax rate. There’s no going back (unless you act fast enough to recharacterize your contribution before filing taxes).
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By contrast, you can convert funds from a traditional account to a Roth account at any point in the future. Your future may present opportunities, planned or unplanned, to convert funds at a significantly lower tax rate.
So, unless you’re very confident that you’re paying one of the lowest tax rates you’ll ever pay in your lifetime, making regular contributions to a traditional IRA likely presents a better opportunity for you to save on taxes.
What goes in must come out
While a traditional IRA offers more flexibility for tax planning, it’s important to note that the ultimate goal once funds are in a traditional retirement account is to get the money out in the most tax-efficient manner possible. What’s more, there’s a bit of a time crunch, too, considering you’ll have to take required minimum distributions, or RMDs, starting at age 72. Ideally, you can convert enough of your traditional retirement account to a Roth in order to minimize the effect of RMDs on your tax planning.
The best times to make Roth conversions are when your other income is low, or when your investments have declined in value (temporarily).
Your income is typically lower when you’re not employed. If the ultimate goal is retirement, that’s going to happen at some point. It may happen sooner if you take a gap year (or two) during your career. Take the opportunity to convert some of your traditional retirement account to a Roth account while living on other savings, like cash or investments in a taxable account that won’t produce significant capital gains taxes.
It may also be opportunistic to convert when your investments have declined in value. That’s because you’re only taxed on the value of your conversion. If you expect your investments to bounce back long term (and you should), you may be able to save significantly on taxes by converting them when they’re down in value versus their all-time highs.
These are opportunities you won’t have in a Roth account to keep your taxes low. And while it’s impossible to predict the future, you can make a pretty good guess as to what’s in store. So, consider how likely it is that you’ll have better opportunities to reduce your taxes in the future by contributing to a traditional IRA than you would if you contributed to a Roth.
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