When preparing your federal income tax returns, one important consideration is whether to contribute to an IRA, and if so, the type to use. For most people, the choice comes down to contributing to a traditional or Roth IRA. Each type offers certain tax benefits that could relieve your present or future tax burden.
A traditional IRA allows you to invest pre-tax dollars, meaning you may be able to lower your taxable income for the current tax year. Traditional IRA earnings grow on a tax-deferred basis, so you won't pay taxes on them until you begin to withdraw the money after age 59 1/2. The Roth IRA uses after-tax dollars, so you won't have the opportunity to lower your taxable income. However, you can receive tax-free distributions of the contributions and earnings upon reaching age 59 1/2.
Lowering Taxable Income
One factor to consider when determining whether to contribute to a traditional or Roth IRA is your need to lower your taxable income. Depending on your income level and whether or not you contribute to an employer-sponsored retirement plan, you may be able to deduct some or all of your traditional IRA contribution and lower your tax burden for the year. For example, if your adjusted gross income is $35,000, a deductible contribution of $5,000 to a traditional IRA lowers your taxable income to $30,000.
Taxes at Retirement
In addition to your present tax situation, you also need to consider the future tax implications when choosing an IRA. While a traditional IRA may afford you the opportunity to lower your current taxable income, you'll have to pay taxes when you begin to make withdrawals at retirement. Many people's taxable income is lower at retirement, which may mean they are also in a lower tax bracket. If you begin to make withdrawals at age 59 1/2 while continuing to work, however, you won't enjoy the advantage of a lower tax bracket.
No Deduction Need
If you're not concerned about lowering your current taxable income, the Roth IRA may be the better choice for you. You won't have to worry about your income level at retirement since you'll receive the distributions without taxation. If you're not sure how long you plan to work or are concerned about your tax obligations after retirement, the Roth can provide important tax benefits in your later years.