One of the most prominent ways to take advantage of tax-friendly regulations is to create retirement accounts. These accounts include 401(k)s or 403(b)s (depending on type of employer), Individual Retirement Accounts (IRAs) and Keogh plans. All of these accounts qualify for preferential tax treatment and therefore are often referred to as qualified accounts. The benefits of deferring taxes can dramatically compound over time. For example, $1,000 invested in an IRA at a tax-deferred rate of 8 percent grows to $10,063 over 30 years. In a taxable account (assuming 28 percent tax rate), the funds would grow to only $5,366.
Roth and traditional IRAs are both effective ways to save for retirement. With a Roth IRA, you contribute money that has already been taxed in exchange for the ability to make tax-free withdrawals upon retirement. In a traditional IRA, your contributions are pre-tax, but you pay taxes on distributions later on. But how do you choose between the two? Your choice depends on how you think your future tax rate compares to your current tax rate. If you assume your individual tax rate is not going to change between now and retirement, then the net result will be the same regardless of which type of IRA you choose. When looking at changing tax rates, it is most important to focus on both the changing landscape of tax rates as a whole, as well as how changes in your income will affect which tax bracket you fall under. Generally, as people age they earn more money and enter higher tax brackets. In this case, and assuming no change in the overall level of taxes, it would be more beneficial to pay the taxes now, at a lower rate. However, if you believe that your tax rate will decrease, then traditional IRAs will be more beneficial.