The decision of whether you should invest in the traditional IRA or the Roth IRA should be based on at least five factors: (1) your need to reduce current taxes through tax deductions; (2) your anticipation of tax rates when you retire; (3) your availability of money to pay the necessary taxes on the Roth IRA; (4) your need for investment flexibility; and (5) your need for estate planning to transfer assets to your heirs.

If you need tax deductions now, the traditional IRA is the best choice. Note, however, that since you are taking a deduction now, you will have to pay taxes on your entire traditional IRA balance (principal and earnings) when you retire. Remember that tax-deferred vehicles have the disadvantage of converting capital gains income (which is taxed at a lower rate, generally 15 percent) into ordinary income (which is taxed at your higher marginal tax rate).

Your anticipation of future tax rates is also an important factor in your decision. If you expect your tax rates to be lower in the future, the traditional IRA is usually best choice. If you expect tax rates to be higher in the future, the Roth IRA is usually the better choice. To see the impact of tax rates on retirement savings, see Learning Tool 28: Traditional versus the Roth: Which Is Better?

If you currently have the extra money available to pay taxes on your retirement plan contributions, your best choice is likely the Roth IRA. If you pay taxes now on the principal, you will never have to pay taxes on any of the earnings again if you withdraw funds after age fifty-nine and a half. In addition, you can theoretically contribute more to the Roth IRA than the traditional IRA. Note that the Roth is an after-tax contribution fund. Therefore, to make the $4,000 contribution in 2007, you must earn $4,000 plus any taxes you must pay on that contribution. If your average tax rate is 15 percent, you would, in essence, be contributing $4,706 in earnings ($4,000 / (1 – .15) before taxes to make the $4,000 contribution to your Roth IRA.

If you need investment flexibility, which in this case means that you think you may need to withdraw some of your retirement funds before retirement (and you would like to withdraw funds without a penalty) the Roth is the better choice. Since you have already paid taxes on the principal amount you contribute to the Roth, you are allowed to withdraw the principal amount without having to pay any penalties or taxes. However, if you withdraw earnings before retirement, you must pay taxes on the earnings plus a 10 percent penalty.

Finally, if you want to leave your retirement money to your heirs, the Roth is usually the better choice. Since taxes are paid up front on the Roth, the money can be left to heirs without the imposition of additional taxes. Assets from a traditional IRA require the payment of taxes before these funds can be distributed to your heirs.