Your Best Path to Retirement Riches

Everyone loves a chance to avoid paying huge amounts of taxes, and for many people, opening a Roth IRA could give you exactly that opportunity. But depending on your particular financial situation, a Roth IRA may not give you a huge benefit over other types of retirement accounts.

Roth IRA madness!
I'll admit that when it comes to picking an IRA, I'm one of the biggest proponents of the Roth IRA that you'll ever find. In exchange for forgoing a current tax deduction on the money you contribute, you get to enjoy tax-free growth for as long as you choose to leave that money inside your Roth IRA. In addition, you won't have to pay taxes when you withdraw that money. That's an amazing opportunity, especially if you're planning to invest for a really long time.

Moreover, when it comes to taxes, there's some value in certainty. You can't be sure what tax rate you'll pay 20 or 30 years from now, but you do know what your tax rate is now. The Roth lets you get those taxes out of the way when they're a known quantity.

Do your own taste test
But anything that requires you to predict what the future will bring makes it really hard to be certain whether a Roth IRA will always work out to be your best option. It's easy to come up with a scenario where it really doesn't make much difference whether you go with a Roth or a traditional IRA.

For instance, say you're a typical investor in the 25% tax bracket and are trying to decide what kind of IRA to use this year. You've got $3,000 to invest right now, but you'd also be willing to invest whatever tax savings (if any) that you earned from your IRA contribution.

If you go with a Roth IRA, you won't get an extra tax break right now, so you'll have $3,000 to contribute. On the other hand, if you pick a traditional IRA, assuming you get your tax refund back before the tax deadline, you can actually contribute $4,000, because you'll get a $1,000 tax break back by deducting your full contribution.

Over the years, that amount can grow immensely. Here are some examples of what some commonly held stocks have done over the past 30 years, just to give you a sense of the magnitude of gains:

Source: Yahoo! Finance.

As you can see, even a single IRA contribution can turn into real money given enough time.

Now, at first glance, you might think the traditional IRA is the obvious choice, since it has a lot more money in it. But remember: that money will get taxed when you withdraw it. In fact, if you assume you're still in the same 25% bracket when you take your money out, an interesting thing happens:

Look familiar? It turns out that after taxes, you have exactly the same amount of money you would have had if you'd gone with a Roth IRA. Put another way, you wouldn't have gotten any benefit at all doing a Roth instead of sticking with a basic traditional IRA.

In fact, if you change the assumptions a little bit, you might do even better with a traditional IRA. If your tax rate goes down in retirement -- something that's certainly conceivable if you go from a high-paying job to living off your investments -- then you'd pay less in taxes, keeping more of your money for your retirement.

Cover your bases
Given the future uncertainty about tax rates, you might want to hedge your bets by splitting your money among Roth and traditional retirement accounts. If you have a regular 401(k) account, for instance, a Roth IRA could help give you tax diversification. If your rates go up, then your Roth will protect you somewhat. If they go down, then your traditional retirement account will be the better move.

Whichever you pick, though, don't pass up using some type of tax-favored account for retirement. The benefits are too good to ignore.