Should You Open a Roth IRA or Traditional IRA?

June 2, 2020 Posted by : Jorge Cardozo
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2020 Tax Filing Deadline Extended: 

In an effort to support individuals and businesses during the COVID-19 pandemic, the federal government has extended this year’s tax deadline to July 15. That means that Americans still have another month to file and pay their federal income taxes for 2019.

But that’s not all: in addition to being granted a few more months than usual to pay their federal taxes, Americans also now have until the July 15 deadline to make contributions to an IRA as part of the 2019 tax year.

What is an IRA?

An Individual Retirement Account, or IRA, is a tax-advantaged savings plan that individuals can leverage to save money towards their retirement. There are two different types of IRA: Roth and traditional. The most important difference between the two is how and when the invested funds are taxed. In a Roth IRA, funds are taxed at the time of the initial contribution, but tax-free withdrawals can be made after that point. In a traditional IRA, taxes are not imposed until withdrawals are made after retirement.

So the key question to ask yourself if you’re deciding between a Roth and a traditional IRA is this: is there reason to believe that my tax rate will be higher (or lower) in the future? If it’s going to be higher, your best strategy will probably be to open a Roth IRA and take advantage of the present tax rate. If there’s evidence to suggest that it’s going to be lower, then you’ll likely be better off opening a traditional IRA.

Why Roth IRAs are Generally a Smarter Option for Millennial Investors

If you are a younger investor it is highly likely that in the future you will be taxed at a much higher rate than your current tax bracket. The problem, of course, is that it’s usually very difficult to predict what tax rates in the future are going to look like.Thankfully, that’s not the only criteria that we can use when trying to figure out whether we should open a Roth or traditional IRA. There are some other significant differences between the two that should be taken into account. And for most young investors, the scales tend to tip in favor of Roth IRAs. Here’s why:

  • Flexible and tax-free withdrawals. As a general rule, you should aim to never withdraw funds from an IRA unless you’re in seriously dire financial straits. That said, if you do ever need to access some extra funds from your retirement savings, you’ll be much better off with a Roth IRA. In contrast to traditional IRAs, Roths will allow you to withdraw contributions (not earnings) without an early withdrawal penalty.
  • Greater investment portfolio diversity. Many employers sponsor 401(k) plans to prove their employees with a tax-advantaged means for saving towards retirement. The tax benefits of 401(k)s, however, closely mirror those that are offered through traditional IRAs. The punchline is this: if you’re currently managing an employer-sponsored 401(k) plan, opening a Roth IRA could ultimately open the door to a wider variety of tax benefits and alternative investing options.
  • Tax-free growth. Since taxes are paid right away, funds in a Roth IRA will continue to grow tax-free until they’re withdrawn after retirement. This feature, in particular, makes Roth IRAs an ideal choice for young investors who still have years (or decades) of savings ahead of them.

How To Take Advantage of this Year’s IRA Contribution Deadline Extension

For the 2019 tax year, you can contribute up to $6,000 to an IRA, or $7,000 if you’re over the age of 50. There is no minimum amount required, but you need to have earned income to qualify.

As we mentioned earlier, you now have until July 15 to make prior year contributions to an IRA. That means that if you don’t currently have an IRA, you still have a chance to open one and kickstart your retirement savings before the end of the tax year. And if you elect to open a Roth IRA, you’ll be able to pay with after-tax dollars; after you make your first contribution, you can sit back and start watching your savings appreciate tax-free.

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About Author

Jorge Cardozo
Jorge Cardozo

Jorge has over eight years of experience in wealth management and economic research, managing more than 600 million USD. He has invested in all types of securities, ranging from traditional assets (fixed income securities and funds, global equity) to alternative assets (real estate, hedge funds, and private equity). Jorge holds an MBA from a top global program.

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