The difference between Traditional IRAs and Roth IRAs are taxes. In a traditional IRA the money you put into the account is tax deferred, meaning you don’t pay income taxes on it this year. The money inside the traditional IRA also grows tax deferred. When you reach retirement age you must pay taxes on all the money you withdraw from your traditional IRA. You can learn more about traditional IRAs here.
In a Roth IRA do pay income taxes on the money this year but the money grows tax free. When you retire you don’t have to pay any income taxes at all. You can learn more about Roth IRAs here.
The trick is that money you put into a traditional IRA will have less impact on your spendable income since you don’t have to pay taxes on it. So if you put in $1,000 you might get $150 back as a tax refund, for example. So the theory is that traditional IRAs help you save a little extra. You could in theory put that extra $150 tax refund to your traditional IRA and save more than you would have in a Roth.
But Roth IRAs are usually still better, here’s why.
Let’s say two identical people with identical investments invested $1,000 per year for 30 years into their IRAs. One had a traditional IRA and one had a Roth. Let’s say the Mr. Traditional actually did take the extra tax return and put it into his IRA. So, in the end Mr. Traditional was actually investing $1,150 while Mr. Roth was only investing $1,000
What would happen?
Mr. Roth would have $161,101. Mr. Traditional would have $184,116. Mr. TraditionalTraditional has a lot more! But don’t forget that Mr. Traditional still has to pay income taxes while Mr. Roth doesn’t. Assuming the same tax rate as above of 15% Mr. Traditional would owe $27,616. Bringing his spendable money to $156.499. Pretty close to Mr. Roth, an actual tax person could probably do the math and get the spendable amounts from each account to be the exact same. (I’m not a tax person in any sense of the word! I don’t even do my own taxes.)
But there are a few questions here that make the Roth quite a bit better for the average person than the story the math tells. First off, what are the odds that Mr. Traditional actually takes his extra tax refund money and sends it to his IRA? Based on the savings rate of the average American I’m going to say that chance is pretty slim.
There is also the question of what to do if the IRA is maxed out. If you max out your traditional IRA you can’t contribute the extra money you get back from your tax refund. You would have to invest that in a non-tax favorable investment. That’s not a terrible thing, but it would impact the amount of your nest egg.
Secondly, these calculations assume the same exact tax rate for life. Ask yourself, will taxes will go up, down, or stay the same before you retire? I hope I’m wrong, but I sure don’t think taxes will be going down. Our income tax rates are actually pretty low when you look at historical tax rates. So if taxes go up the traditional IRA gets worse. At least in a Roth you are protected from increasing tax rates.
Last but not least, the Roth gives you flexibility that the traditional IRA doesn’t. Forget about the fact that you can withdraw your contributions without penalties after 5 years. (A nice place to save for kids college if you don’t have to max out your IRA, btw!) Even in retirement the Roth gives flexibility that the traditional IRA doesn’t. Sure you can withdraw as much as you want out of either account, but in a traditional the amount you withdraw affects your taxes. Let’s say you have planned out to take $30,000 per year from your traditional IRA and you know how that will affect your taxes. Then you get sick and need an extra $10,000 for medical bills. You will pay more on that $10,000 than you “should” have because it will push you into the next tax bracket. Where as in a Roth you don’t owe any taxes so that $10,000 hit is just that, nothing more.
Roths rule! Traditionals drool!