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October 15, 2009

Traditional IRA v. ROTH IRA

Filed under: Personal Finance, Retirement, Simulation — Tags: , , , , — thebalancedspreadsheet @ 3:01 pm

With the Dow Jones Industrial Average once again breaking past the 10,000 point plateau yesterday, a lot of talk right now is about investing into the market.  Usually people invest in either a 401(K) through their work or an Individual Retirement Account (IRA).  There are two kinds of IRAs, Traditional IRA and ROTH IRA.  I am going to try and give a brief explanation of each and what I recommend to use. 


While there are some key differences between the two, there are also some similarities.  First, the maximum contributions are the same.  For 2009 you may contribute up to $5,000 ($6,000 is over 50) into either a Traditional or ROTH IRA.  Also, you can start withdrawing from you IRA with no penalty after you turn 59½.


There however are some minor differences. You can only fully contribute to a ROTH IRA if you income is less then $105,000 for single filers and $166,000 for married filing jointly.  But there are no income limits for contributions to a Traditional IRA.  But you do have to start making mandatory withdrawals starting at age 70½ with a Traditional IRA, opposed to no mandatory withdrawals with a ROTH IRA. 

The major difference though between Traditional and ROTH IRA is the different tax treatments each receive.  Traditional IRA contributions are pre-tax, meaning that all contributions and growth will be taxed at the time of withdrawals, while ROTH IRA contributions are after tax, meaning contributions are taxed at your income rate at the time you contribute.  But when you make ROTH IRA withdrawals, both the contributions and growth are tax free!


For our comparison let’s assume you make $50,000 this year and are less than fifty years of age and contribute the $5,000 maximum.  Under a Traditional IRA you would pay Federal income taxes on $45,000 ($50,000-$5,000), while under a ROTH IRA you would pay federal income taxes on $50,000.  So under a Traditional IRA you would have an immediate tax savings.  But over the long term what would the difference be when you are ready to retire? 

If you put $5,000 each year for 30 years into an IRA averaging a conservative 10% annual rate of return you would have ~ $942,000 at the end of the 30 years!  That means you would have $150,000 worth on contributions (30 x $5,000) and ~ $792,000 of growth!  With a ROTH the $792,000 growth would be 100% tax free, while with a Traditional IRA the entire growth would be taxed on when you make withdrawals from you account.  So while you have to pay the taxes on the ROTH IRA initially up front, tax free growth on a ROTH IRA would be a better long term value at retirement then a Traditional IRA because of the tax implication.

Well that is a short and brief explanation of the difference between Traditional and ROTH IRA’s.   Hopefully this answers any questions you might have before making your 2009 contributions.

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