Roth IRA vs. the Traditional IRA

Here's an interesting article courtesy of Marotta Asset Management dealing with the Roth IRA and the traditional IRA -- and which one's better for you. Here goes:

Albert Einstein referred to compound interest as “the greatest mathematical discovery of all time.”  However, earning compounding interest in a tax free environment is even better. Individual Retirement Accounts were created to give Americans an incentive to save for retirement by combining the benefits of compounding interest with a favorable tax status.

While both traditional and Roth IRAs allow investments to grow tax-free, they differ in their tax treatment. Your particular circumstances will determine which IRA is most tax-efficient for you. But in many cases, a Roth IRA offers some of the biggest tax advantages. So, how do you know which IRA to choose?

The Traditional IRA

As long as you (or your spouse) receive a paycheck, you are eligible to open a traditional IRA. And, depending on the size of your paycheck, your contributions may even be tax deductible. All contributions to an IRA grow tax-free, allowing you to take full advantage of compounding interest year after year. However, when it comes time to take a withdrawal, you’ll pay taxes on the money withdrawn - the vast majority of which may be earnings.

For example, T.J. opens an IRA and makes a tax-deductible contribution of $1,000. After ten years he retires and decides to drain the entire account. His initial investment has grown to $10,000. Because T.J. owns a traditional IRA, he must pay taxes on the full withdrawal amount of $10,000.

If you are tempted to postpone withdrawals from your IRA to avoid paying the taxes, think again. Soon after your 70½ birthday, all IRA owners must begin their Required Minimum Distributions. A traditional IRA will not let you enjoy the tax-free earnings forever.

Whether you are hoping to fund a traditional IRA or Roth IRA, caps on yearly contributions are the same. Account owners may contribute $4,000 per year in 2006 and 2007. Contributions limits rise to $5,000 in 2008. Thereafter, contribution limits will increase in $500 increments, indexed to inflation. All account owners 50 and over are permitted an additional “catch up” contribution of $1,000 per year.

In order to get money back out of your IRA without incurring a penalty, you must be 59½ or older. A handful of special circumstances will permit you to take early withdrawals. However, all non-qualified distributions will be subject to a 10% penalty in addition to any federal and state income tax.

The Roth IRA

The Roth IRA bears some similarities to its counterpart. Like the traditional IRA, contributions grow tax-free. But the defining difference of the beloved Roth IRA is in the way funds are taxed, or - better said - not taxed. While all contributions to a Roth IRA are made with after-tax dollars, the growth on the account is not subject to taxation.  When funds are withdrawn, neither the contribution nor the earnings are taxed. That’s right. All the growth in the account is tax-exempt, not just tax-deferred as with the traditional IRA.

Let’s assume that, this time, T.J. decides to opens a Roth IRA. He funds his Roth with an after-tax payment of $1,000. Ten years later, he decides to drain the entire account. Again, T.J.’s initial investment has grown to $10,000. But this time, with a Roth, he can withdraw all the funds, tax-free.

And if that wasn’t enough, Roth IRAs do not force you to begin required minimum distributions at age 70½. This difference is an effective planning strategy. Because there are no required distributions from a Roth, it should always be the last tax qualified dollars to be used in retirement. You are best to leave your Roth investments untouched and happily compounding.

While the face value of two IRAs may be the same, the taxes owed on traditional IRAs may dramatically reduce the actual amount you bring home. Sometimes it is clearer to plan ahead by looking behind. Remember back in the ‘50s and ‘60s when the top marginal tax brackets were close to 90 percent?  In comparison, today’s top tax bracket of 35 percent is a deal. Historically, income taxes have not been this low since 1931. Now is good time to move money into a Roth. Tax rates are probably going to increase, not decrease.

Making the right choice between a traditional IRA and Roth IRA is not always clear. Changing tax laws, your current tax bracket, your current and expected income, and how long you have until retirement are important factors in the formula. The foresight of an experienced professional can help you plan ahead. To find a fee-only financial planner in your area, visit www.napfa.org.

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I'm a big fan of the Roth IRA and highly recommend you use one as part of your overall retirement plan (I do!).

For more on retirement planning and saving, see Best of Free Money Finance: Retirement Posts.

Comments

[Foobarista]

It's probably time for a similar discussion about the Roth 401K, which just got Congressional approval to go past 2010. Roth 401Ks are very cool...

[Mike]

Other advantages to a Roth IRA:

If you could afford to contribute more to a traditional IRA, then contributing to a Roth IRA effectively allows you to do that.

Withdrawals from a Roth IRA do not cause Social Security benefits to be taxed, as do withdrawals from tax-deferred savings such as traditional IRAs or 401(k) accounts. Once past the exclusion amount, another $1 of income can result in the taxation of $.50 or $.85 of Social Security benefits which effectively increases your marginal tax rate. For example, you could defer taxes while in the 25% bracket, realize that money as income in the 15% bracket but if $.85 of Social Security benefits are taxed you're effectively at the 27.75% bracket. Since the exclusion amounts are not indexed for inflation, more and more people will be hit by this as time goes on.

[Jeff]

If I'm correct, he would only be able to take out $5,000 tax-free as he has to wait 5 years before taking any of his principle out without penalty. This is what I recall finding before I opened our Roth's.

Thanks,
Jeff

[Mike]

Jeff, I'm obviously talking about withdrawals during retirment. You have to be 62 to draw Social Security retirement benefits, which is greater than the age of 59 1/2 to escape penalties on IRA withdrawals.

Please check online resources about IRA withdrawals. Don't know how to find them? Try www.google.com.