“Should I contribute to a traditional IRA or a Roth IRA?” If you are like most aspiring retirees, this question has plagued you for years. Unfortunately, the correct answer is the proverbial, “It depends.” It depends on a number of factors that impact your personal financial situation, including the current tax framework.

The Basics

Traditional and Roth IRAs both provide significant tax benefits. The key difference, however, is the timing of those benefits. Contributions to a traditional IRA are tax deductible, whereas contributions to a Roth IRA are not. Conversely, withdrawals from a traditional IRA are fully taxable, whereas withdrawals from a Roth IRA are tax-free. In other words, you avoid taxes when you contribute money to a traditional IRA, and you avoid taxes when you withdraw money from a Roth IRA.

The Impact of Tax Reform

Many Americans suddenly find themselves in a lower tax bracket as a result of recent tax law changes. Because any future tax reform legislation will likely raise these historically low rates, Roth IRAs present a unique opportunity for individuals seeking to maximize the benefitof this favorable tax environment. Consider the following hypothetical scenario.

The Curious Case of Sam Traditional and Sally Roth

Sam Traditional and Sally Roth are 30-year-old co-workers at Santa Land, LLC. Both of them are paid an annual salary of $50,000. Thanks to the new tax law, Sam and Sally find themselves in the 22% tax bracket. This is down from the 25% tax bracket they were in last year. They are both currently single and plan to stay that way due to some unfortunate online dating experiences. After reviewing their financial plans with their Stifel Financial Advisors, they have both determined that they would like to retire at age 65. In order to help facilitate a successful retirement, Sam has decided to open a traditional IRA. Sally has decided to open a Roth IRA. Both Sam and Sally will contribute the maximum allowable amount to their respective retirement accounts each year (i.e., $6,000 until age 50 and $7,000 from age 50 until retirement). Sam will also invest the tax savings he realizes each year into a taxable account. Because Sally will not realize tax savings when contributing to her Roth IRA, she will make no additional investments.

After illustrious 35-year careers at Santa Land, LLC, Sam and Sally decide to retire. While meeting with their Stifel Financial Advisors to review the performance of their respective investments, Sam and Sally both learn that they have averaged a 5% annual rate of return. Furthermore, they learn that due to an unpopular tax hike passed by Congress, they are now in the 25% tax bracket.

This is where the similarities end. The chart below illustrates the value of the assets Sam and Sally have available to pursue their respective retirement spending goals.

Despite all of their similarities, Sally has $44,368 more than Sam to spend in retirement. This represents the potential value of contributing to a Roth IRA.