Key Points
You never escape income taxes, but IRAs can help you control when you pay them, possibly lowering your lifetime tax payments.
Roth IRAs are exempt from required minimum distributions, a boon if it’s your intent to leave some of your retirement account for an heir.
Many investors choose to have both a workplace 401(k) account as well as a self-directed IRA held with a retail brokerage firm.
The $23,760 Social Security bonus most retirees completely overlook ›
It's a question investors have been asking themselves since they were first given the choice back in 1998: Do I take my tax break now and pay taxes later, or do I pay my taxes now and enjoy tax-free IRA distributions later? A traditional IRA offers the former. A Roth IRA allows for the latter. That is to say, unlike traditional IRAs (sometimes called contributory IRAs), contributions to Roth retirement accounts aren't tax deductible. Also unlike traditional IRAs, though, distributions from Roth accounts aren't taxable.
There's still no clear answer to the question. Or it might be more accurate to say that the answer changes from one investor to the next, since everyone's situation is unique. There is one common criterion every investor should consider, however, before choosing one or the other.
An option for every scenario
If you aren't familiar with the difference between a contributory IRA and a Roth IRA, here's a brief primer.
Individual retirement accounts have been around since 1974, created by that year's Employee Retirement Income Security Act. That's when it was becoming clear that corporate pensions alone -- the source of most peoples' retirement incomes up to that point -- simply weren't up to the task any longer on their own. Workers embraced their new self-directed retirement savings vehicles too, using contributions to these accounts to lower their taxable income. Withdrawals from these ordinary IRAs, however, are treated as taxable income by the IRS.
Congress took the idea a step further in 1978, introducing workplace 401(k) accounts to take more of the ever-growing pressure off of employers' still-struggling pension plans by allowing workers to tuck away much more of their income for retirement. Like the IRAs introduced just four years earlier, 401(k) accounts allow for pre-tax contributions. The IRS just collects what its due on the back end, when money is taken out of these accounts.
Then in the late 1980s Delaware Senator William Roth and some of his colleagues introduced a different idea. Rather than allowing for tax-deductible contributions to IRAs now and taxing this money and its growth later, why not forego the tax break linked to contributions to retirement accounts and instead allow tax-free distributions from these IRA accounts as they are withdrawn in retirement? That idea became law in the Taxpayer Relief Act of 1997, leading to the creation of Roth IRAs in 1998.
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