This Popular Last-Minute Tax Move Might Be Wrong for You
In some cases, though, grabbing that last-minute tax deduction with a traditional IRA isn't your best move. Instead, you might be able to get a much larger benefit down the road by using a different type of retirement account: the Roth IRA.
The Difference Between Roth IRAs and Traditional IRAs
Roth and traditional IRAs are both retirement accounts, but the way they get treated at tax time is much different. Only traditional IRAs can give you an up-front deduction to reduce your tax liability when you contribute. Roth IRA contributions are never deductible on your taxes.
Roth IRAs have an offsetting advantage down the road. In retirement, you have to pay taxes on your traditional IRA withdrawals. Roth IRA withdrawals are typically tax-free, potentially saving you a bigger tax bill in retirement.
When Waiting Can Make You Richer
In deciding whether to use a traditional IRA or a Roth IRA, the main question is whether what you give up in a current tax deduction is worth the future benefit of tax-free retirement income down the road. It's impossible to predict with absolute certainty what the future will bring, but there are some general situations in which you can be reasonably certain that one choice will be better than the other.
If you have relatively little income now, then the odds are good that you're in a low tax bracket, and therefore, the deduction you'd get from a traditional IRA contribution won't be worth very much. For instance, if you contribute $1,000 to a traditional IRA and you're in the 10 percent tax bracket, then your deduction will only save you $100 on your tax bill.
Meanwhile, by the time you reach retirement, you might well have enough income to be in a much higher tax bracket. In the above example, if you've climbed up to the 25 percent tax bracket in retirement, then when you withdraw that $1,000, you'll owe $250 in extra taxes. In addition, you'll also owe that higher rate on all the income that your original $1,000 investment generated over the course of your career.
In that situation, you probably would've been better off using a Roth IRA. You wouldn't have gotten that $100 in tax savings now. But you would save the $250 in future taxes, and all the earnings from your investment would also be free of tax.
When You Should Grab the Deduction and Run
On the other hand, many people who have higher incomes now anticipate that they could be in a lower tax bracket by the time they retire. After all, retirement means you won't be getting any money from work anymore, and that should lower your overall income and send you into a lower tax bracket.
To change the above example slightly, say that instead of being in the 10 percent bracket, your income is high enough that you'd pay taxes at a 35 percent rate right now. As a result, a $1,000 traditional IRA contribution would produce tax savings of $350 rather than $100.
In that case, whether a Roth is better than a traditional IRA is more complicated. The $350 you save now with a traditional IRA is worth more than the $250 in future taxes on your initial investment, but you don't know how much in future earnings you'll have. A lot depends on what you plan to do with your current $350 savings. If you reinvest it, then you'll usually be better off having done the traditional IRA. But if you just spend it, then you can end up better off with the Roth even with a lower rate in retirement, depending on how long you have until you retire and what returns you earn on your investments.
Grabbing a tax deduction can be attractive, and contributing to any type of IRA is always a smart move. But before you automatically go with a traditional IRA, be sure to check to see whether you might be better off with a Roth. In the long run, it might end up being a better choice.
Motley Fool contributorDan Caplingernever met an IRA he didn't like. You can follow him on Twitter@DanCaplingeror onGoogle+. Check out our free report on one great stock to buy for 2015 and beyond.