A guide to achieving tax diversification

Tyler Kert
Tamarack Wealth Management

If you’ve found it difficult to figure out the difference between a Roth IRA and a Traditional IRA, you’re not alone. These retirement accounts are easily confused and just when you think you’ve got it, someone throws in a “conversion” or talks about “income limits” and now your head is spinning. But correctly understanding these accounts and utilizing them will pay major dividends for your financial future.

So, let’s try to simplify it. Both Roth and Traditional IRAs are great tools for saving for retirement. The trick is choosing the one that makes the most sense for you in your current stage of life. 

Starting with the Basics

A Traditional IRA gives you a tax break now. The money you contribute can be deducted from your income on your tax return at the end of the year which means you lower your current tax bill. Your investments grow tax-deferred, and you’ll pay taxes later when you withdraw the money in retirement.

A Roth IRA flips that model. You don’t get a deduction on your tax return when you contribute, but your money grows tax-free and more importantly, you don’t pay any taxes when you take it out in retirement.

Which One’s Better?

Unfortunately, there is no one-size-fits-all. It depends on your current tax bracket, your expected future tax bracket, and how much flexibility you want in retirement. This is where planning comes in. 

If you’re just starting your career or having a lower-income year, chances are your tax bracket is pretty modest. That’s when a Roth IRA often makes the most sense. Why? Because you’re paying taxes on your contributions now, while your rate is low, and then you’re locking in tax-free income later in life when your tax rate might be higher. If you think tax rates will go up in the future for the nation as a whole, Roths again look appealing because you won’t have to worry. 

If you’re in your peak earning years, your tax rate may be relatively high. In that case, a Traditional IRA might be better especially if you’re eligible for the deduction. Deferring taxes until retirement could save you a lot on your current tax bill. Plus, many retirees end up in a lower tax bracket, so you can pay less on withdrawals than you would today.

Do You Want More Flexibility in Retirement?

Roth IRAs offer some unique advantages when it comes to retirement income planning. For one, you’re not required to take minimum distributions (RMDs) from a Roth, whereas Traditional IRAs require you to start withdrawing money (and paying taxes) at age 73. Many retirees find RMDs to be frustrating, especially when they don’t need to withdraw money from their accounts to live on. A Roth removes this burden and gives you more control, allowing you to let your money grow longer or pass it on to heirs more tax-efficiently.

Furthermore, Traditional IRAs come with a catch: when you withdraw money, it’s taxed as ordinary income. That’s fine if you’re in a lower bracket in retirement. But if you end up needing a big chunk of cash, the tax bill can sting.

Roth IRAs let you withdraw your contributions anytime, tax and penalty-free. That flexibility can come in handy in an emergency. Earnings are tax-free too as long as you’re 59½ and the account’s been open at least five years.

The Bottom Line

If you like the idea of tax-free income in retirement and you’re in a lower tax bracket now, the Roth IRA is a home run. If you’re looking for a tax deduction today and expect lower taxes later, a Traditional IRA can be a smart move.

What’s better than choosing correctly? Having both. That’s right, diversification doesn’t just apply to your mix of investments and choice of stocks, bonds, real estate, etc. No, a balanced portfolio will also have a mix of pre-tax and post-tax retirement accounts because only then will you be prepared no matter what comes your way. At the end of the day, no one actually knows if tax brackets will go up or down in the future. And personally, I’d rather be right with some of my money than wrong with all of it. Yes, in the short-term you can usually find one of these accounts to be more advantageous. But given the uncertainties of the future, hedge your bets and don’t have all your eggs in the same tax basket. 

This material is for informational purposes only and does not constitute financial, investment, or tax advice. Please consult your tax advisor or financial planner to discuss your specific circumstances before making any decisions.

Tyler Kert, a licensed financial advisor and CPA, provides financial planning and tax consulting services at Tamarack Wealth Management in Cashmere, WA.