There are many confusing rules surrounding individual retirement accounts (IRAs), but here’s the basic choice you face: With a Roth IRA, you pay taxes on the money now, and then pay no taxes when you withdraw your cash and the gains during retirement. With a traditional IRA, you can deduct your contributions now, but when you retire you pay tax on the money.
So the standard financial advice is that if you expect higher taxes when you retire, go for the Roth, while if you expect your tax rate will go down, go the traditional route. I don’t like that advice, for two reasons. First, it requires a lot of guesswork. In addition to correctly estimating what your retirement income will be, you have to know what tax rates will be in 20 or 30 or 40 years.
Here’s my take: By making the maximum contribution to a Roth (which is named for the late Delaware Senator William V. Roth, Jr.) you are saving more money for retirement than if you max out a traditional IRA. Why? Because you are paying the tax now, and you’ll get to keep 100 cents of every dollar in that account. With a traditional IRA, you’ll have to give 10 or 20 or 25 cents of every dollar to Uncle Sam as you make withdrawals.
Make no mistake: Since you’re putting after-tax dollars into the Roth, you have to earn roughly $1.25 (depending on your tax bracket) for every buck you invest. But consider the human element; what some economists call behavioural finance. When we have money, we tend to spend it. As our cash flow increases, lo and behold, our expenses seem to grow right along with it. So if you divert that money straight into a Roth, you may not miss it. But once you’re retired and on a fixed income, you’ll thank the younger you for prepaying those taxes.
Roth Limits & Options
There are income limits above which you cannot contribute directly to a Roth IRA or deduct IRA contributions. For the 2011 tax year (the return you file in April 2012) the limits were $179,000 (married filing jointly) and $122,000 (single). There is an option for big earners however: Anyone can convert a traditional IRA to a Roth. You just have to pay taxes on any untaxed money within the traditional IRA (such as earnings and any deductible contributions).
This excerpt from “Worth It … Not Worth It?” was reprinted with permission from Business Plus/Grand Central Publishing.