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23 Jun 2005

The Difference Between a Roth IRA & Traditional IRA

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by Jesse Mecham

I could probably explain the difference between a Roth IRA and a traditional IRA in one sentence (don’t expect me to do that though):

With a Roth, you tax the seed. With a traditional IRA, you tax the tree:

All right, there you have it.

We’ll do a little number crunching to fully illustrate the difference between these two retirement vehicles. Check out the article on Roth IRA Basics if you want to get into specific rules and regulations regarding the Roth specifically. If you just want to know the difference between the Roth and traditional, stick around.

With a Roth, you contribute after-tax money. So, if I have taxable income of $50,000 and put $4,000 into my Roth, I still pay taxes on $50,000. With a traditional IRA, your contribution is pre-tax. Given the same situation of $50,000 taxable income, if you put $4,000 into your traditional IRA, you would pay taxes on $46,000 (50,000-4,000). Traditional IRA contributions are deductible. Roth contributions are not.

Let’s get an investment going:

All right, so what can actually be invested? Well, if you can only afford to invest $4,000, then, after taxes, your Roth would be funded with $3,000. $1,000 less than your traditional IRA. That’s because the traditional IRA contribution is deductible.

Echo to base. The seed has been planted“. Let’s say we contribute $4,000 before tax each year to our investment. We do this faithfully for 30 years. Let’s also assume we get an 8% return on our investment (after inflation) for both the Roth and traditional IRA. Here’s what our nest egg would’ve grown to given these assumptions:

So the difference between the traditional IRA and Roth IRA nest eggs? You have another $113,283 in your traditional IRA.

Except we haven’t paid Uncle Sam

So am I trying to tell you that it doesn’t matter? It’s all a wash in the end? Hardly. The one key assumption I haven’t talked much about is the tax rate. If you contributed starting at age 35 (start earlier!), until you were age 65, we’re talking about a 30-year spread of future history (?) there. I assumed your tax rate at 35 would be 25 percent. However, who’s to say that Uncle Sam won’t raise the tax rate to 35 percent? Or, what if you’re earning significantly more money during retirement (now wouldn’t that be sweet?), so you’re naturally in a higher tax bracket, maybe 37 percent?

What if Uncle Sam lowered the tax rate to 10%…

You get my point. The tax rate is an unknown variable. I personally choose the Roth IRA for the following reasons: I’m a college student. My tax rate is virtually zero percent. I am fully expecting my tax rate to go up in the future. Also, I sure hope I’m in the highest tax bracket when I retire; that means I’ll be making a ton of money.

The difference between the Roth IRA and traditional IRA lies in your current tax rate, and your expected tax rate upon retirement. Remember, it’s not set in stone which one you’ll use forever. You can contribute and not contribute at will, even doing both simultaneously (subject to certain limits).

1,006 more words to finalize my point.

Your Next Step

Remember, budgeting is not restrictive. You won’t be spending less, you’ll be spending right. You can do this! Today. Right now. What do you have to lose? Except all that debt and stress. (Ok, so kind of a lot.)


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