When you first start saving for retirement, deciding which type of account you'll use is tricky -- Roth IRA or traditional IRA?
Picking the right investments is a huge part of your investment return, but how you pay taxes also matters. The type of account you choose can either enhance or take away from your returns. If these situations apply to you, a Roth IRA could be your best bet.
Before you consider contributing to a Roth IRA, you should make sure you qualify. You must meet certain income requirements to contribute to a Roth IRA. If you're an individual, your modified adjusted gross income (MAGI) must be under $139,000 for the year 2020. If you're married and file jointly, your MAGI must be under $206,000 . Moreover, if your income is between $124,000 and $139,000 for singles or $196,000 to $206,000 for joint filers, you'll only be able to make a partial Roth contribution.
1. You expect your taxes to be higher in retirement
There's a good chance that you'll make less in retirement than you did when you were working. But if you do a great job of saving or have a lot of retirement income sources, you could make more, and that could push your taxes higher.
With a traditional IRA, you forgo taxes in the present and pay them in the future when you start withdrawing your money. With a Roth IRA, your contributions get added after you pay taxes, which means you don't owe taxes when you make distributions. Because of this, a traditional IRA works out better if you make more money while working, while a Roth IRA is best if you earn more in retirement.
A Roth IRA is often the better choice if you are at the beginning of your career. You will probably get pay raises as you progress in your profession. Assuming you won't get more of a benefit from the tax break that a traditional IRA provides, you can leverage a Roth IRA when you're in your lower wage earning years.
2. You want flexibility with IRA withdrawals in retirement
You get a tax break when you contribute to a traditional IRA, but at some point in time, Uncle Sam wants you to pay taxes on this money. That time comes in your early 70s when you must take your first required minimum distribution (RMD). If you turned 70 1/2 in 2019, the IRS required that take your RMD by April 1, 2020. If you turned 70 1/2 this year or will in the future, the age you take this distribution got pushed back and now you must take it by April 1 of the year following when you turn 72. Your RMD will take into account your age, life expectancy associated with it, and your IRA account balance on Dec. 31 of the previous year.
Because it is required, you'll owe a hefty 50% tax on any part that you don't take out. You might get to your RMD age and not need your money, or find yourself in a bear market and not want your account suffering even more because of a withdrawal, but that doesn't make the requirement go away.
You're forced to take distributions from a traditional IRA but not from a Roth IRA. Instead, with a Roth, you can take withdrawals when you want and continue letting your accounts grow tax-free if you choose.
3. You're uncertain about your future
As much as you can speculate about what your future will look like, you may not know. That's why you can use a Roth IRA as a hedge if you're uncertain. This option works especially well if you already contribute to a traditional 401(k) and get the same tax benefits there that a traditional IRA would offer.
If you can also open up a Roth IRA, some of your contributions will leverage the pros of traditional retirement accounts and some will take advantage of the positives that Roth accounts possess. You won't be putting all of your eggs in one basket and should get some benefit no matter where you end up in the future.
After surviving the ups and downs of the market, you don't want unnecessary taxes eating away at the money you've worked so hard to save. Limiting the amount of money you pay in taxes will result in more money going toward your retirement and the activities you enjoy. Picking a Roth IRA when it works best for your situation is the best bet for ensuring this happens.