Q. If I add money to a ROTH IRA will it help reduce the taxes I pay?
A. The Roth IRA does not provide any tax-reducing benefits now (this year), but it will in the future when the money is withdrawn (in retirement). I think the best way to explain how this works is to compare the types of IRAs. Individual Retirement Arrangements (IRAs) come in two types; Roth and Traditional. The difference between the two is the timing of the taxation.
Traditional IRA. If you qualify, you can put money into a traditional IRA account and take a tax deduction for it in the year the contribution to the Traditional IRA is made. The money going into the Traditional IRA is not taxed, but when you take money out of the account it is taxed as income to you at that time. (Whether or not you qualify depends on your income and if you have access to an employer-sponsored retirement plan (i.e. 401K) where you work.)
Roth IRA. If you qualify you can put money into a Roth IRA. You do not receive a tax deduction for your contribution, but the money can be withdrawn tax free after you reach age 59 ½. The money going into the Roth IRA is taxed, but the money coming out is not taxed. (Whether or not you qualify to put money into a Roth IRA depends on your income.)
This raises the question of which gives the greater lifetime tax benefits; Roth or Traditional. I don’t like to give generic, one-size-fits-all advice because everyone’s financial situation is unique, but in this instance I will go out on that limb. If you are under age 45 you will almost always see a greater lifetime tax benefit by using a Roth IRA. That’s because neither the amount you contributed to the account, nor the investment income that accumulates in the account is taxed when it is withdrawn. If you are young and that money has 15 or more years to grow before you start withdrawing it, you should have a significant amount of tax-free money available to you in retirement.
Many people over age 45 will also receive greater lifetime tax benefits from a Roth IRA. There are a lot of variables that go into determining which type of IRA is best for you. If you need help identifying and navigating those variables I recommend consulting a professional financial planner.
Paul Allen, Bank On Coach, Member of Financial Planning Association of Hampton Roads