New Tax Rates Mean It’s Time to Rethink Retirement Strategy

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individual retirement account
Don Mammoser /

Which option will provide you with more money at retirement, a traditional IRA or a Roth IRA?

It’s a question every saver should weigh — but that’s particularly true in 2018 and future years, due to the recent overhaul of the federal tax code.

The vast majority of the overhaul provisions — including lower income tax rates — take effect this year. And your 2018 tax rate is one of the key factors in whether you are better off saving in a traditional or Roth retirement account.

So, if your taxes stand to drop because of the overhaul — which is expected to be the case for most folks — you would be wise to re-examine which type of retirement account makes the most sense for you.

Traditional versus Roth IRAs

The differences between traditional and Roth retirement accounts generally hold true whether you’re talking about an individual retirement account (IRA) or a 401(k) account. This article will focus on IRAs, though, because anyone can open one regardless of their employment situation.

The major difference between a traditional IRA and a Roth IRA is when you pay taxes on contributions.

With a traditional IRA, you pay no taxes on contributions when you make them. So, for example, if you added $5,500 to a traditional IRA last year — the maximum contribution allowed for people under age 50 — you can deduct that $5,500 from your 2017 taxable income when filing taxes this year.

Instead, you will pay taxes on your traditional IRA contributions when you withdraw money from the account during retirement. The money will be taxed at whatever your federal income tax rate is when you make withdrawals.

With a Roth IRA, it’s the other way around. You pay taxes on contributions in the year you make them.

Thus, if you contributed $5,500 to a Roth IRA last year, you cannot deduct it when filing your 2017 taxes. So, you’ll pay taxes on that $5,500 based on your 2017 tax rate.

The upside here is that you pay no taxes on withdrawals from a Roth IRA during retirement, as we explain in “4 Big Reasons to Make a Roth IRA Part of Your Retirement Strategy.”

In a nutshell, the right choice between a traditional and Roth IRA often — but not always — comes down to:

  • Your income tax rates for the years during which you will be contributing money to the IRA
  • Your income tax rates for the years during which you will be withdrawing money from the IRA

What it means for you

Generally, folks are better off contributing to a Roth IRA if they expect to be taxed at a lower rate during their contribution years compared with the rates they pay during their retirement years.

On the other hand, folks are generally better off contributing to a traditional IRA if they expect to be taxed at a higher rate during their contribution years, and a lower rate during their retirement.

That is why your tax rate for 2018 and the coming years is one key to whether you should save money in a traditional or Roth account right now, and in the future.

Keep in mind that the changes from the federal tax code overhaul to individual tax rates are not permanent. They apply only to tax years 2018 through 2025.

So, most likely, your tax rate will be lower from 2018 through 2025, and go up again starting in 2026.

For many taxpayers, today’s lower tax rates seem to strengthen the argument for contributing to a Roth IRA, at least for the next eight years. But that’s not true for everybody. Before making such a major decision, it might be wise to discuss your situation with a fee-only financial adviser.

What’s your take on the traditional versus Roth IRA debate now that tax rates are expected to drop? Share your thoughts below or on Facebook.

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