One question people face as they plan for retirement is whether to use a traditional IRA or a Roth IRA. There are advantages to both, but there's one important reason a traditional IRA will tend to work best for the average American: taxes.
Traditional vs. Roth IRAs
Traditional and Roth IRAs are investment accounts that the government has designed to encourage people to save for retirement. They do so by acting as a legal tax shelter for money contributed to them.
In the case of a traditional IRA, each eligible person can contribute up to $5,500 a year, or $6,500 if you're 50 or older. You can then claim your contribution as a deduction on your income statement, thereby reducing your current tax liability.
If your taxable income is $75,000, for instance, you could lower it to $69,500. Doing so would reduce your federal income tax bill by $1,375. You are then taxed when you withdraw funds from the account in retirement.
A Roth IRA works differently. Contributions to this type of account can't be claimed as a deduction. However, once the money is in the account, it's allowed to grow tax free. Unlike a traditional IRA, in turn, when you withdraw money from a Roth IRA in retirement, those funds are exempt from income taxes.
Shifting tax rates
There are plenty of reasons a person would prefer one type of IRA over the other type, but one of the biggest reasons revolves around taxes.
As the argument goes, assuming you're equally eligible to contribute to a traditional and a Roth IRA, then you should make the decision based on when you're likely to face the highest tax brackets.
If you expect to make more money in retirement, which seems unlikely, then you should go with a Roth IRA, which won't further boost your income and be taxed at your highest marginal tax rate.
Alternatively, if you expect to make more money before you retire, which seems most likely, then you'll want to take advantage of the immediate tax benefits associated with a traditional IRA.
Which is best for you?
While there's no one-size-fits-all rule one can use when deciding whether to choose a traditional IRA or a Roth IRA, it's nevertheless fair to say that the majority of Americans would be better off with the former, insofar as income taxes are concerned.
You can see this by looking at data from the 2016 Consumer Expenditure Survey, which breaks down how much the average person pays in federal, state, and local income taxes by age.
At all ages between 25 and 64, the average American pays more in taxes than he or she does in retirement -- after turning 65. It's not even a close call.
Consequently, if one's goal is to get the most out of the tax advantages offered by these two types of accounts, it seems fair to say that the traditional IRA will generally be better than the Roth IRA for most Americans.
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