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How to Invest in Retirement Plan: Compare Traditional IRA and Roth IRA
By Wayne Weis
What kind of retirement plan should you have? If you are one of the very few people who have a defined benefit pension, the choice has been made for you. If your employer matches contributions to your 401(k) retirement plan, then the choice is clear: you should choose whichever plan your employer matches, to take full advantage of the matching contributions. If, like most people nowadays, you are essentially left to fend for yourself in retirement, with a little help from Uncle Sam, you have to choose between a Traditional IRA or a Roth IRA. In a Traditional IRA, contributions are made with before-tax dollars (i.e. they are tax deductible), and taxes are deferred until distribution, with penalties for early withdrawal and mandatory distributions after retirement age.
In a Roth IRA, contributions are made with after-tax dollars, can be withdrawn any time without penalty, and only the earnings on the contributions (from interest, dividends or capital gains) are taxed on distribution. Many people are frustrated by the choice between the Traditional and Roth IRAs, with many websites launching into complicated discussions about future tax rates and expected income on retirement, both of which are unknowns. Actually, the choice is simple. If you are confident that you will be able to contribute the maximum allowed under the Roth IRA ($5000 per person in 2010), you should go with the Roth IRA instead of the Traditional IRA. The reason is simple. With the same contribution amount, you are actually saving MORE with the Roth IRA because you are using after-tax dollars. More savings means more taxes deferred, and faster compounding from your investments. The effect is especially pronounced if 1) you save the maximum allowed, and 2) you save with a high yield vehicle, such as stocks. That is why people who are serious about saving for retirement consistently choose the Roth IRA. In addition to your IRA account, you are going to have set aside some additional after-tax dollars to save for retirement anyway, so why not take full advantage of the tax deferring allowed by the government. Traditional IRAs are more for people who have difficulty contributing the full amount allowed. In a Traditional IRA, by using before-tax dollars, you are effectively asking Uncle Sam to chip in some money towards your retirement plan now because you cannot come up with enough cash, though you have to pay Uncle Sam back in the future. Whereas with the Roth IRA, Uncle Sam agrees to defer taxes on any earnings on your investment, allowing you to contribute more, and allowing your earnings to compound tax-free. Although eventually, after you have withdrawn your original contributions and started to withdraw your earnings, taxes will be levied on those earnings, you retain full control over the distribution timing. You can choose to withdraw the bare minimum required for your expenses, and thus keep your taxes at the lowest tax bracket compatible with your standard of living. With a Roth IRA, your earnings will be the last bit of money distributed from your IRA account , after you have depleted the principal, thereby ensuring years of tax-free compounding. This tax-free compounding effect, although also present in a Traditional IRA, is muted because of the lower contributions and the mandatory distributions. So, if you are serious about saving for retirement and are able to make the full annual contribution of $5000, always choose the Roth IRA.
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 | | Grace liked this intel. Feb 7, 2012 |  | | R Foreman liked this intel. Feb 7, 2012 |
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This sounds very complicated to me. I am so glad I am self employed.
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May, 2012
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