Deciding factors: if the contribution is deductible, tax bracket in retirement versus tax bracket today, income levels today, current age, and availability of retirement plan at work.
If the question is whether you should invest in an IRA account (including traditional and Roth), then the answer is YES (capital bold yes)*. If the question is whether you should contribute to a traditional IRA or a Roth IRA, then the answer is ‘it depends’.
It primarily depends on several factors. Two of these factors are the most important: whether the contributions are taxable in the current taxable year, and whether you expect your tax rate to be higher or lower (as compared to the current rate) in retirement.
The basic idea of an IRA account (traditional and Roth) is 'Money is taxed by the IRS only once' - either you get taxed now OR you get taxed when you withdraw the money in retirement.
If you get taxed now, you are making a Roth contribution (that goes to the Roth IRA account). If you choose not to be taxed now, you are contributing to a traditional IRA account (from which the withdrawals are taxed).
Traditional IRA accounts are what is called a tax deferred account. Roth IRA accounts are what is called tax exempt accounts. So in traditional IRA, you pay taxes at the end while in Roth IRA, you pay taxes upfront (today).
Basic rules about IRA accounts
- You need to have earned income in order to be able to contribute to an IRA account.
- There are no income limits for contribution to Traditional IRA – anyone can contribute irrespective of their income levels (up to the limit).
- Traditional IRA contributions tax-deduction phases out for higher income levels.
- Roth IRA contributions are never deductible. And Roth IRA contributions phase out with higher income levels.
- Traditional IRA withdrawals are taxed at ordinary income (except the non-deductible contributions portion).
Traditional IRA or Roth IRA?
Use the following flow chart to understand whether you are better off contributing to a traditional IRA or a Roth IRA:
The following table summarizes what the above flow chart explained in detail:
MAGI stands for ‘Modified Adjusted Gross Income’ – In most cases, it is very close to AGI (Annual Gross Income), actually slightly higher.
*Caveat 1 – You can afford to keep the money invested till retirement.
*Caveat 2 – The only investment vehicle that comes close to an IRA (and can even be better) is a 401k contribution. I will compare 401k and IRA contributions some other time but for the sake of this article – let us assume that you have maxed your 401k contribution ($18,000 for 2015). And now you are wondering whether you should invest in an IRA – the answer is a no-brainer YES.
OneMoreDime Special: Ordinarily the IRS imposes income limits on those who can contribute to the Roth IRA (for example, those single filers in 2015 who make more than $131,000 are not eligible). But with the “Back door entry to the Roth IRA“, anyone can contribute.
OneMoreDime Special: If you are under the age of 50, the total you can contribute (across your traditional IRA and Roth IRA) is $5,500. If you are unable or unwilling to make a reasonable guess your tax rate at retirement, consider splitting the contributing – $2,750 in a traditional IRA and $2,750 in a Roth IRA.