Roth IRA vs. Traditional IRA: Which Type of Account Should I Choose?

Whether you should choose a traditional IRA or a Roth IRA for your retirement savings essentially comes down to one question: When do you want your tax break -- now or in the future?

While both types of retirement savings accounts offer favorable tax treatment -- that is, ways to shield some of your money from taxation -- the mechanics of how and when they deliver tax savings are very different.

Beyond the tax question, these accounts have other features that might sway your decision one way or the other. We'll wade into the details in a moment -- and our IRA Center can help you sort out the details if you don't know where to begin -- but for those who specifically want an answer to the question "Should I choose a Roth or traditional IRA?" in less than 350 words, here it is.

If you'd prefer to lower your taxes today and defer them until a later date, a traditional IRA is the answer
The IRS allows you to deduct the amount of money you contribute to a traditional IRA from your taxable income for the tax year in which you make the contribution, so long as you meet certain criteria. That means a traditional IRA offers immediate tax savings. However, years later, when you start taking money out of the account for retirement, Uncle Sam will come calling, and those taxes you deferred will come due. As you make withdrawals, you'll pay your ordinary income-tax rate on all money you withdraw. (To see whether you qualify to receive the full tax benefits of a traditional IRA, see What Is a Traditonal IRA?)

If you'd rather pay more in taxes today in exchange for a tax pass in retirement, the Roth is the way to go
At first glance, the Roth IRA seems stingy in the tax-break department. You don't get to deduct the amount of your contribution from your taxable income, which means you'll pay income taxes on the full amount you made during the year. The tax payoff comes years later for the Roth IRA investor: When you start taking money out of your Roth account for retirement, you'll owe the IRS nothing -- zip, zero, zilch! (To see whether you're eligible to contribute to a Roth, head to What Is a Roth IRA?) 

In short, you should aim to get your tax break when you'll face the biggest tax bill, be that now or in retirement.

But I don't know when I want my tax break
Oh, hey. You're still here. That means you probably want a little more information and time to contemplate your current and future tax rates.

You need to consider a lot of variables before you can decide whether you should pay taxes now or later. And gazing into your crystal ball to conjure a clear picture of your future tax rates might seem futile. After all, who really knows what the future holds, what your income might be, how future politicians will change the laws, or what will happen to tax rates?

Our resident Motley Fool retirement expert, Robert Brokamp, CFP, has some guidelines that will get you pretty far in making the "Roth or not" decision:

• If you're single and have $37,450 or less in taxable (not gross) income or are married and have $74,900 or less in taxable income, you're in the 15% tax bracket in 2015. The Roth is probably your better bet.
• Younger workers tend to benefit more from the Roth, as most people reach their peak earnings in their late 40s or early 50s.
• Keep in mind that most people drop into a lower tax bracket once they retire.
• Given large government deficits and underfunded entitlements, tax rates will have to go up. That burden is more likely to fall on younger and higher-income Americans.

Beyond the current-or-future tax-bracket question, here are some other things to consider.

10 questions to help you figure out which type of account is right for you
Allow us to take a moment to get to know you. By answering the following questions (and using our IRA calculators to further customize your comparison), we'll get you even closer to figuring out whether the Roth IRA or the traditional IRA is right for you.

1. Are you covered by a retirement plan at work? If you are, your ability to deduct contributions to a traditional IRA may be severely limited -- or altogether eliminated. For example, if you're covered by a plan at work and your modified adjusted gross income is more than $71,000 for single taxpayers or $118,000 for married taxpayers, then you're ineligible to deduct a traditional IRA contribution. This makes the Roth (assuming you're eligible) the way to go.

2. Will you need the money before age 59-1/2? That's the age when the IRS allows you to withdraw money from IRAs without socking you with a 10% early-withdrawal penalty. However, if you absolutely need access to your money before then, the Roth gives you the flexibility to do so on better terms than a traditional IRA.

With a Roth IRA, you're allowed to withdraw your contributions (the principal) at any time without paying a penalty or income taxes, so long as the money you're taking out has been in the account for at least five years. (If you withdraw earnings from a Roth IRA before age 59-1/2, then regardless of the five-year holding period requirement, you'll still have to pay the 10% early-withdrawal penalty.)

With a traditional IRA, both contributions and earnings are subject to the 10% early-withdrawal penalty, as well as income tax.

There are circumstances in which you can make early withdrawals from either a traditional IRA or a Roth IRA without penalty -- for example, when you're purchasing your first home, paying unreimbursed medical expenses, or paying for higher education. However, with a traditional IRA, you'll still have to pay income tax on those withdrawals, so you won't have as much left over to cover those expenses.

3. Are you less than 10 years away from retiring? The conventional wisdom is that a traditional IRA is better if your tax bracket today is higher than what it will be in retirement. If you're close to your retirement due date, you can use an online tax calculator to estimate your current and in-retirement tax liabilities and feel pretty comfortable with the accuracy of those projections.

4. More than 10 years away? The further from retirement you are, the less clarity you'll have on your future tax situation. You can still use online tax calculators to make estimates. But if you're in the dark, then go with a Roth to take advantage of the other benefits it offers.

5. Are you a young whippersnapper in your first job? The further you are from retirement, the bigger the potential for a Roth to deliver the most after-tax wealth for you. This is especially true if you're at an early stage in your career and living on ramen noodles in a two-bedroom apartment shared by five roommates; you'll likely be earning much more, and paying much higher income taxes, a few decades down the road. Rock the Roth. Your future self will high-five you with its robot hand.

6. Are you already retired? Traditional IRAs require that you start withdrawing money from the account in the year you turn age 70-1/2. The Roth has no such "required minimum distribution," or RMD. With a Roth, you're free to let your investments grow tax-free for as long as you live. Beyond that, non-taxable distributions from a Roth aren't included in the calculation that determines whether your Social Security benefits will be taxed, while taxable distributions from a traditional IRA are. So in this instance, the Roth may deliver extra tax savings on your withdrawals.

7. How close are you to age 70-1/2? In addition to requiring you to start taking RMDs at age 70-1/2, the traditional IRA cuts you off from making contributions at that age, even if you're still working. The Roth has no such restrictions: You can continue to contribute to a Roth IRA well after you blow out the candles on your 71st birthday cake.

8. Do you want to leave the accounts to your heirs? Roths are better than traditional IRAs if you want your beneficiaries to receive the most money without having to pay income taxes on it (although the dough may be subject to estate taxes). Roths retain their tax-free status ad infinitum in most cases. On the other hand, heirs must always pay income taxes on inherited traditional IRAs. Also, since you're not required to start taking money out of your Roth at any time and can continue to add money for as long as you live (if you qualify for a Roth), you can leave your loved ones a bigger pile of money.

9. Do you invest in a lot of high-growth, tax-inefficient investments? Smart asset location (parking your investments in the right kind of account) can be just as important to your long-term wealth as smart asset allocation (choosing a good mix of investments). The main factor in what should go in which type of account is -- you guessed it -- tax efficiency. Let your investing strategy be your guide:

• Roth IRA: Since your withdrawals in a Roth are tax-free, it behooves you to fill this account with your most tax-inefficient investments -- the ones that will generate the highest taxes because of growth, higher dividends, or high turnover (in mutual funds). Candidates include small-cap stocks, real estate investment trusts, and high-turnover and/or high-yielding funds, especially if they have above-average growth potential. It's also better to use a Roth if you engage in active-trading stock strategies.
• Traditional IRA: Since the money you withdraw from a traditional IRA is taxable, it serves best as a holding cell for the most tax-efficient investments in your portfolio. Those include corporate bonds, Treasuries (especially TIPS), high-yielding and slower-growth stocks, and diversified commodities funds. However, if you don't have a Roth or the account isn't very large, go ahead and include any investments listed in the Roth category in your traditional IRA, because you'll still get the tax-free growth.

10. Are you ineligible for a Roth IRA and a deductible traditional IRA? Don't fret! You can still contribute to an IRA and get the advantage of tax-deferred growth on your investment earnings. For this you would use a non-deductible traditional IRA. True, you won't get the up-front tax break -- but that means when you take those contributions out, they're tax-free (though you'll still pay ordinary income taxes on the gains). So keep good documentation of your contributions to a non-deductible IRA so you don't pay more than you're required to in taxes.

And now, since we still have your attention, we leave you with this handy comparison table that shows most of what we just covered. (And don't forget to check out our IRA Center if you still have questions.)

Roth IRA vs. traditional IRA cheat sheet

Sources: Motley Fool Rule Your Retirement service and IRS.gov.