Investors have had only bad choices lately. If you put money in ultra-safe investments, then you've seen your interest rates plummet to near-zero levels. But even stocks that many used to consider among the safest -- stocks like AT&T
Faced with that irresolvable dilemma, it's nice to consider a choice that is a no-lose scenario rather than a no-win: picking between a traditional or a Roth IRA.
Back in January, I took a look at several factors to consider in choosing the right IRA for you. Income limitations force one choice or the other for many. What investments you like also matters: slow-growth income-producers like royalty trust BP Prudhoe Bay
But what most of these factors boil down to is your tax situation: specifically, what you pay now versus what you expect to pay in the future. So let's take a closer look at that question.
Peering into the crystal ball
One of the hardest things to try to predict is where tax rates will be in the future. Since the massive tax reform act in 1986, every new administration has made significant changes to income tax laws. And it appears almost certain that this streak won't be broken by the current administration, which has already proposed several changes that would raise many tax rates back to late-1990s levels.
For IRA planning, however, making an educated guess at future tax rates is critical to your analysis. Put simply, you have to weigh two things:
- How big a tax deduction you get from contributing to a traditional IRA and what that tax deduction is worth to you in total tax saved. With a Roth, you forego the upfront deduction and its accompanying tax savings.
- How much you'd end up paying in taxes when you make withdrawals from a traditional IRA -- taxes you'd avoid completely with a Roth.
You can answer the first question when you do your taxes this year. If you're eligible to deduct your entire IRA contribution, your tax bracket tells you how much you'll save in taxes with a traditional IRA. But what you'll pay in the future is impossible to know for sure.
Some rules of thumb
Still, it's reasonably safe to make some general assumptions:
- If you're in a low tax bracket now -- 10% or 15% -- a traditional IRA deduction won't translate into much tax savings. Go with a Roth.
- If you're in a middle bracket now -- 25% or 28% -- guess how big a nest egg you'll have after you retire. Even though that traditional IRA deduction is worth a lot, you might actually be in a higher tax bracket after you retire -- making a Roth the smarter move.
- If you're in a top bracket now -- 33% or 35% -- you'll usually be better off taking the current deduction from a traditional IRA if you're eligible. But it's not a sure thing, especially if you expect to have substantial income in retirement and tax rates rise from their current low levels.
Lastly, one thing to consider is your own discipline. Regardless of which IRA you pick, your eventual account balance should be the same -- but you'll owe taxes on the traditional IRA, while the Roth will never get taxed. To make up the difference, you really need to take the tax savings from your traditional IRA deduction and invest it separately to make up the difference. If you know you'll just spend it instead, then a Roth could mean a more prosperous retirement in the long run.
If all else fails and choosing just seems too hard, don't fret. Whichever choice you make, you're taking a step toward ensuring a secure retirement. So you can't lose!
For more on how IRAs can help you:
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Fool contributor Dan Caplinger went with the Roth and has never looked back. He doesn't own shares of the companies mentioned in this article. Coca-Cola is a Motley Fool Inside Value recommendation. Baidu is a Motley Fool Rule Breakers selection. Apple is a Motley Fool Stock Advisor pick. Coca-Cola is a Motley Fool Income Investor recommendation, while US Bancorp is a former one. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy holds the keys to your financial health.