You know that now's a great time to invest and save for your future. But with so many choices, you may have trouble deciding which one will make the most difference in the long run. With employer 401(k) plans, tax-deferred annuities, and more types of accounts with "IRA" in their names than you know what to do with -- well, it can get intimidating fast.
To narrow things down, let's focus on just one decision: picking between a traditional IRA and a Roth IRA. In comparing these two methods for saving for retirement, you'll find a number of differences that could make one a lot more beneficial than the other.
Now or later
Traditional IRAs and Roth IRAs have plenty of things in common. They both let you shelter income without paying tax during your career. You can invest without worrying about tax impacts and burdensome recordkeeping.
But of course, there's a big difference: The money you contribute to a traditional IRA is tax-deductible right now, while Roth IRA contributions aren't. That makes a traditional IRA sound like a no-brainer, but there's a trade-off: On a traditional IRA, you have to pay taxes when you take money out after you retire. With a Roth, on the other hand, your withdrawals are completely tax-free.
So in other words, it comes down to a simple question: Do you want the biggest benefits right now, with a current tax deduction -- or later, with tax-free treatment for the rest of your life?
What you can do
Unfortunately, many investors don't get the choice. Those with incomes above IRS limits can't contribute at all to a Roth IRA, and other restrictions keep workers who have 401(k) accounts at work from deducting their traditional IRA contributions if they earn more than a certain amount.
But assuming you're eligible for both accounts, how should you decide? The two most important factors are the taxes you pay now and how you want to invest the money inside your IRA.
The 401(k)/Roth tag team
If you have a standard 401(k) plan at work, a Roth IRA often makes the most sense. Here's why: The standard 401(k) gives a current deduction like a traditional IRA, but it lets you contribute over three times as much money. So using a Roth IRA gives you what some call tax diversification: you'll pay today's rates on some of your savings, while paying future tax rates on your 401(k) withdrawals.
Without a 401(k), however, the question's a lot closer. With the possibility of much higher tax rates down the road, the Roth gives you a bird in hand. But paying taxes before you have to is always a difficult decision, so unless you're in a low tax bracket right now, both types of IRAs have their benefits.
The other important factor is how you like to invest. In general, I like to separate investments into three categories:
- Blue-chip dividend-paying stocks like Procter & Gamble
(NYSE:PG)and IBM (NYSE:IBM)that you can buy and hold for decades. With current low tax rates on dividends and long-term capital gains, these make good holdings for a taxable account.
- Other income-paying investments, including bonds and REITs (real estate investment trusts) like Simon Property Group
(NYSE:SPG)and Vornado Realty (NYSE:VNO). These won't grow as much as other investments, but they benefit a lot from tax deferral. So these do well in traditional IRAs.
- Stocks with a lot of growth potential, including Rule Breakers recommendations Google
(NASDAQ:GOOG)and AeroVironment (NASDAQ:AVAV)and small-cap stocks like Innophos (NASDAQ:IPHS), make good Roth candidates. It's especially valuable not to have to worry about capital gains tax along the way, because you may not be able to buy and hold these volatile stocks as long as you can with more stable companies.
Regardless of whether you go with a traditional IRA or a Roth -- or split the difference and open two accounts -- you'll be ahead of those who stick with taxable accounts. Over time, the savings can make a huge difference in your standard of living after you retire.
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Fool contributor Dan Caplinger has all kinds of retirement accounts. He doesn't own shares of the companies mentioned in this article. Google and AeroVironment are Motley Fool Rule Breakers picks. The Fool owns shares of Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy makes choices easier to make.