The difference between choosing to invest in a Traditional IRA over a Roth IRA could be tens of thousands of dollars over the course of your investing career. There are pros and cons to both, and choosing the correct one depends on your circumstances now as well as your circumstances at retirement age.
What is an IRA?
An Individual Retirement Account (IRA) is a tax advantaged account which allows an individual to set aside and invest money for retirement. Essentially, you’re giving up some flexibility in what you can do with your retirement money – when you can take it out, what you can invest it in – in order to gain tax benefits. Over the long-term, these tax advantages can provide you with significant savings.
Two basic terms you’ll need to understand before we get started:
Contribution – Putting money into your IRA.
Distribution – Taking money out of your IRA.
Traditional IRAs are tax-deferred retirement accounts. This means that any money you contribute to a traditional IRA isn’t taxed in the year you earn it, like normal income. Instead, it’s taxed when you take the money out in retirement. If your tax rate is 20% and you know you can afford to invest $100 per month after taxes, because you aren’t taxed up front you can really afford to invest $120 per month into a Traditional IRA with the same impact to your wallet. This gives you increased buying power, and is the great benefit to a Traditional IRA. Taxes are collected on distributions based on your tax rate when you retire, not during the years you contribute.
In general, people expect to have a lower tax rate in retirement because of having lower expenses from not having a mortgage payment, driving less, etc. If you expect to make less in retirement than you do today, consider investing into a traditional IRA.
Traditional IRAs are restrictive in when you can take distributions. Money distributed before 59-and-a-half incur a penalty unless you qualify for an exception. Aside from that, distributions are taxed as normal income once you’re in retirement.
Roth IRAs are different from Traditional IRAs in a couple of important, distinct ways. Roth IRAs are taxed on contributions like ordinary income. So, if you can afford to contribute $100 after taxes, you really can only afford $100. There is no increased buying power with Roth IRAs. However, all distributions are tax-free, including the growth from interest and dividends your money has earned over the years. In essence, you pay tax up front, so you don’t pay it in retirement. This can provide a better benefit compared to a traditional IRA in the long run, especially if you expect your tax rate to be equal or higher than what it is today.
There’s also an extra benefit to Roth IRAs. While Traditional IRAs have penalties associated with early distributions that aren’t part of an exception, Roth IRAs allow the owner to take distributions on all contributions (money you put in) at any time, for whatever reason. Any distributions on growth from interest and dividends before 59-and-a-half are still subject to penalty. It’s better if you leave contributions in until your account matures, but having the knowledge that the funds are accessible if needed can put your mind at ease. You could also use this perk to retire a little bit early if you’ve been contributing long enough.
What Happened to Fictitious Felicia
Traditional-Felicia invests $120 per month into a Traditional IRA, starting at age 24. She decides to retire at age 64, because that’s when the government told her to retire. Traditional-Felicia did pretty well with her investments overall, earning an average of 10% per year. At retirement, Felicia’s Traditional IRA portfolio would total $701,066.61. If she took her IRA out at a rate that cost her 20% in taxes, that IRA is worth $560,853.29 after taxes.
Roth-Felicia invests $100 per month into a Roth IRA (she had to pay that other $20 that traditional-Felicia invested into taxes), starting at age 24. She decides to retire When She’s 64 because she’s a die hard Beatles fan, so it’s somewhat symbolic. Roth-Felicia also earned 10% and had a 20% income tax during her contribution years. Felicia’s already paid all of her taxes on the Roth IRA, so at 64 her IRA is worth $584,222.17.
In this totally fabricated but completely plausible example, the Roth-Felicia won out by $23,368.88. The Traditional IRA would be even or come out ahead if the income tax dropped in retirement, or if Felicia earned a lesser average rate of return. Understanding which factors apply to you will influence which plan is better for your circumstance.
Where to Open an IRA
There are many online brokers with whom you can open an IRA. These are my top recommendations:
When to Start Contributing to an IRA
Ten years ago. Investing early is the single biggest factor in investing success. Compounding your interest takes time, and if you’re not already investing in your future, you’re too late!
In all seriousness, investing early is important, but you shouldn’t stretch yourself so thin that you can’t make ends meet now. Also, if you’ve got outstanding credit card debt, pay those off first and then start investing.