Thursday, September 30, 2010

The Hidden Benefits of a Roth IRA

One of the most basic retirement planning decisions is whether to put your money into a Roth IRA or a Traditional IRA.  Is it better to take the tax deduction now or later?  Before we get into the meat of this article, I want to review quickly the differences between a Roth IRA and a Traditional IRA.  Note that, generally speaking, the same differences apply to a Traditional 401(k) and a Roth 401(k).

With a Traditional IRA, you don't pay any taxes on the amount you deposit (subject to certain rules).  However, when you withdraw the money in retirement, you pay taxes on whatever you withdraw.  This is the "pay later" choice.

With a Roth IRA, you have to pay taxes on the money you deposit.  However, when you withdraw the money in retirement, you get to take your money out tax free.  This is the "pay now" choice.

When choosing between these two retirement vehicles, your choice often comes down to whether or not you want to pay taxes now or pay taxes later.  The general rule of thumb is that if you are going to be in a lower tax bracket in retirement, you want to pay taxes later (i.e. Traditional IRA).  Otherwise you should pay now (i.e. Roth IRA).

Here are three examples that illustrate this common rule of thumb.  In each example, I compare the results of investing $5000, which is the maximum contribution amount for 2010, in each type of IRA for 20 years assuming a 5% annual return.

Example 1:  25% Tax Bracket Now, 25% Tax Bracket in Retirement


Type of IRAInitial InvestmentInvestment After TaxesAccumulated Value, 20 years, 5%Withdrawn Amount After Taxes
Traditional$5,000.00$5,000.00$13,266.49$9,949.87
Roth$5,000.00$3,750.00$9,949.87$9,949.87

Example 2:  25% Tax Bracket Now, 33% Tax Bracket in Retirement

Type of IRAInitial InvestmentInvestment After TaxesAccumulated Value, 20 years, 5%Withdrawn Amount After Taxes
Traditional$5,000.00$5,000.00$13,266.49$8,888.55
Roth$5,000.00$3,750.00$9,949.87$9,949.87

Example 3:  33% Tax Bracket Now, 25% Tax Bracket in Retirement

Type of IRAInitial InvestmentInvestment After TaxesAccumulated Value, 20 years, 5%Withdrawn Amount After Taxes
Traditional$5,000.00$5,000.00$13,266.49$9,949.87
Roth$5,000.00$3,350.00$8,888.55$8,888.55

As you can see, these examples confirm the standard rule of thumb when it comes to IRA.

However, astute readers will notice that there is a twist to this rule which nobody every points out.  The twist is that the $5000 limit is a before tax limit for Traditional IRA's, but it is an after tax limit for Roth IRA's.  What that means is that you effectively can invest more into a Roth IRA in a given year than you can in a Traditional IRA.

When you invest in a Roth IRA, the money that you are paying towards taxes on your investment amount does not count towards the $5,000 limit.  If you are in the 25% tax bracket, you can set aside $6666.67 for retirement.  25% of that, or $1667.67 goes towards paying taxes, while the remaining amount, $5000, can be invested.  This means that with a Roth IRA, you can allow more money to grow tax free than you could with a Traditional IRA.

Let's redo the examples showing the actual maximum investment that we can make in each type of IRA:

Example 4:  25% Tax Bracket Now, 25% Tax Bracket in Retirement

Type of IRAInitial InvestmentInvestment After TaxesAccumulated Value, 20 years, 5%Withdrawn Amount After Taxes
Traditional$5,000.00$5,000.00$13,266.49$9,949.87
Roth$6,666.67$5,000.00$13,266.49$13,266.49

Example 5:  25% Tax Bracket Now, 33% Tax Bracket in Retirement

Type of IRAInitial InvestmentInvestment After TaxesAccumulated Value, 20 years, 5%Withdrawn Amount After Taxes
Traditional$5,000.00$5,000.00$13,266.49$8,888.55
Roth$6,666.67$5,000.00$13,266.49$13,266.49

Example 6:  33% Tax Bracket Now, 25% Tax Bracket in Retirement

Type of IRAInitial InvestmentInvestment After TaxesAccumulated Value, 20 years, 5%Withdrawn Amount After Taxes
Traditional$5,000.00$5,000.00$13,266.49$9,949.87
Roth$7,462.69$5,000.00$13,266.49$13,266.49

Note how you can accumlate more in a Roth IRA under all three circumstances.  Of course, this is due to the fact that you are putting more money into your Roth IRA up front, so in a sense it isn't a fair fight.  However, what it does show is that you can put more tax-advantaged money towards your retirement using a Roth IRA.  This is just another thing to consider when you are trying to decide which investment vehicle to choose.

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