Here are some basic differences between a Traditional IRA and a Roth IRA:
- Contributions to a Traditional IRA may be deducted from your adjusted gross income at tax time.
- Contributions to a Roth IRA are not tax deductable.
- You will pay taxes on money you withdraw from a Traditional IRA.
- You will not pay any taxes on the money you withdraw from a Roth IRA.
- In a Traditional IRA, you must be at least 59 ½ years old to withdraw without a penalty.
- In a Roth IRA, you can withdraw your contributions at any age without a penalty, but earnings on your money must wait until 59 ½ to be withdrawn penalty free.
- In a Traditional IRA, you must begin withdrawing money shortly after you turn 70 ½ years old.
- In a Roth IRA, you do not have to take withdrawals even after turning 70 ½.
Of course there are conditions and complications to both Traditional and Roth IRA’s – income limitations, phase-out of deductibility, etc. but for purposes of simplicity, we won’t go into all of the rules affecting either plan at this time – that is for later discussions, or discussions with your tax advisor.
Will Tax Brackets Increase in the Future?
One argument for the Roth IRA is the fact that no one knows what the individual tax rates will be in the future. Will the tax rates increase or decrease? No one knows, but based on past experience, the government is great at raising taxes but not so great at lowering them.
But we do know what the current tax rates are right now, so the question then becomes; which type of IRA should a person contribute to – a Traditional or a Roth?
Let’s Look at an Example…
Let’s say you are a 25 year old person who is just beginning to invest, with plans of retiring at 65, or 40 years from today and you are in the 15% tax bracket.
You want to invest $200 per month ($2400 yr) into either a Traditional IRA or a Roth, but you want to know the advantages and disadvantages.
Based on a 4% rate of return, in 40 years, the total in either IRA would be $141,898.
Remember, when you withdraw from a Traditional IRA, you will pay taxes based on your current tax rate at that time. In this example 15% of $141,898 is $21,285, leaving you a net of $120,613.
But, had you invested in a Roth IRA, you can withdraw your entire $141,898 without paying a single dime to the government.
For Seasoned Investors the Roth Has a Huge Advantage
Let’s say you have been investing for a long time and have accumulated a nice nest egg.
If that nest egg is in a Traditional IRA, shortly after you turn 70 ½, the tax man will be knocking at your door – he will demand that you begin to withdraw some of your money and pay taxes on that withdrawal – whether you want to or not. This is something a lot of seniors dread, the “required minimum distribution” or RMD, and it is a way for the government to start collecting their taxes on your money.
But, if your nest egg is in a Roth IRA, you won’t be hearing from the tax man. You can leave your money in a Roth as long as you want, benefiting from tax free growth. You can rest assured knowing that when you do want to withdraw some money, you won’t owe any money in taxes – zero, nada, zilch.
Experts have differing opinions which type of IRA is best, but most agree that a Roth IRA makes sense if you feel you are going to be at the same tax bracket or higher when you retire. If you feel you are going to be in a lower bracket, then the decision becomes more difficult.
Here are a couple of articles for more information:
http://www.fool.com/money/allaboutiras/allaboutiras03.htm
http://www.rothira.com/traditional-ira-vs-roth-ira
In making your decision, it is always in your best interest to consult a tax adviser first.
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