Thursday, September 5, 2013

Retirement Accounts: Roth v. Traditional

We already know that retirement accounts can be an employer sponsored plan (401(k)) or an individual plan (IRA) (see this post for a refresher).

But did you know that each of those accounts can be either a Roth or a traditional account? Or what that means?

Basically Roth vs. traditional is a question of
pay (your taxes) now or pay them later. Say you go the Roth route. You take $1,000 and invest it in a Roth IRA. You don't get a deduction for that $1,000, so that means you've already paid taxes on it. The money grows tax free (which is a wonderful thing), and when you're ready and eligible to start taking money from it, you don't owe any taxes on the distributions (because you've already paid taxes on it). So if you earn 10 percent on that $1,000 over 40 years it will become $45,000, none of which you will owe tax on when you pull it out to go on your dream vacations or whatever it is you want to do when you retire.

A traditional account is basically the reverse. You can deduct your contributions to your traditional retirement account, so you haven't paid taxes on them yet. They still grow tax free, but when you take the money out, you have to pay taxes on whatever you withdrawal.

Think of it like a highway. You take your little nest egg and you drive down the road of time and steady earnings. You've got to pay the tax toll at some point. The question is, do you want to pay it at the beginning, with a Roth, or at the end with a traditional. Generally, it's a better idea to pay the toll when you think the rate (i.e., your tax bracket) will be lower. For a lot of people starting out, you'll be in a lower tax bracket at the beginning of your career, so that would make a Roth a better choice. Personally, I like the idea of having the taxes done with and out of the way as well.


Obviously there are a lot of other ticky-tacky details that this explanation doesn't cover, but check this out for a more thorough comparison.

Tell us-- Do you think you'll open a Roth or a traditional retirement account?

Ask away-- Are there any terms you want defined or clarified?




6 comments:

  1. I'm all about maximizing the Roth while I can. Above a certain income level you get phased out of being allowed to contribute to a Roth IRA. I only wish I had known about it sooner so I could have started putting my retirement money there sooner.

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    1. Very, very good point. The income limitations will sneak up on some people. Here they are for 2013: http://www.irs.gov/Retirement-Plans/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-For-2013

      The income limitations for rollover contributions to IRAs has been removed (as in you can contribute to a traditional IRA and then rollover to a Roth at any income level), but as this article points out-- it may be problematic if you are doing a partial rollover http://www.forbes.com/sites/josephsteinberg/2012/12/12/warning-about-roth-ira-conversions-often-misunderstood-irs-rule-can-cost-you-money-and-aggravation/

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  2. I'm also in the Roth Fan Club. I have a hard time imagining a future in which we'll have lower tax rates than we do now (both because of income reasons and political reasons). Our goal is to completely max out both of our Roth contributions ($5,500 each for 2013, so $11,000 total). We're not there quite yet, but we hope to be, soon.

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  3. I have even thought to myself that the returns from a Roth IRA are likely high enough that I should have started while I was still in college, even if it meant more student loans. That would have meant six more years of money in there, and in there earlier with that much more potential to grow (compounded interest 101 style). Any thoughts on this?

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    Replies
    1. I think this really depends on your personal comfort level and ability to deal with debt. After weighing out the numbers, which I'm guessing would side with investing early in a Roth IRA while a student, I think you need to weigh that out with non-financial factors, like stress produced by having additional loans, etc.

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    2. Good point. It was a hypothetical. Realistically, I probably could have worked an on campus job more than just the 2 hours a week that I did and put all that money toward retirement, rather than student loans. Retirement just wasn't even on my radar until two years after I graduated!

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