Published on April 28th, 2014
Sometimes individuals are eligible to contribute to an IRA or Roth IRA. If a person is eligible to contribute to either plan, must then consider the more important question, which plan, traditional IRA or Roth IRA is the better plan? The answer – it depends.
An IRA is a tax deferral plan. Money is contributed for a given tax year, the amount of the contribution is deducted from income before calculating the tax, reducing income taxes for that year. The IRA account is invested. No tax in paid on the interest, dividends, and investment profits earned each year while they remain in the account. The IRA contributions and earnings grow over time. Income tax must be paid on all withdrawals from the IRA account.
A Roth IRA is a savings plan. Money is contributed for a given tax year, the contribution is not deducted from income, and there is no tax savings for that tax year. The Roth IRA account is invested. No tax is paid on the interest, dividends, and investment profits earned each year while they remain in the account. The Roth IRA contributions and earnings grow over time. If guidelines are followed, no income tax is paid on any withdrawals from a Roth IRA account.
Let’s compare. IRA’s provide a benefit several ways. They make it easier to save by reducing taxes in the year of contribution. They can reduce overall taxes paid if tax rates are higher at the time of the contribution than at the time of retirement. They allow earnings to grow unreduced by taxes along the way. (It may seem likely that tax rates will be lower on retirement than during earnings years. But it is not as often the case as one may expect – especially given new health care taxes and the recent trend toward raising rates.) Because Roth IRA earnings are tax free, higher investment returns, higher tax rates at the time of withdrawal compared favor the Roth. Ultimately the key factor is time. The longer the money is remains in the account, the greater the tax free earning benefit of the Roth IRA.
Here is an example using a conservative 30% income tax rate and a 4% per year rate of return. Saving $3,000 per year for 30 years in a Roth IRA, total $90,000, the value will be $168,254 tax free. Same savings in an IRA leaves $150,022 after taxes, assuming the annual tax savings form the IRA contribution is invested also. Using a 6% rate of return the results are $237,175 for the Roth IRA and $205,282 for the IRA.
So those under 25, 30, 35, 40, or 45 years of age should consider the Roth IRA highly. For those over 45 the decision requires closer analysis.
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