Invest in a Traditional IRA or a Roth IRA?

Deciding whether to invest in a Traditional IRA or a Roth IRA can be a difficult decision, especially if you are unaware of the differences.  A Traditional IRA is an approach typically taken with an employer sponsored plan where before-tax dollars are contributed, thus allowing the employee/investor to invest more money over the life of the IRA.  However, a Traditional IRA is subject to income tax at the time of withdrawal (typically retirement).

On the other hand, a Roth IRA is funded with after tax dollars, and none of the principal or growth of the fund is subject to taxation at withdrawal.  All tax has been paid before money is ever invested, and the government allows for tax free growth.  Sounds like the better option, huh?  Lets look at example and find out.

This graph shows the result of 30 years of investing between a Traditional IRA and Roth IRA, assuming the investor gets an 8% return, contributes $200/month to the Traditional IRA, and only $160/month with a Roth IRA (due to an assumed 20% taxation before investing).

As you can see, the Traditional IRA accumulates approximately $60,000 more than the Roth IRA.  But wait Jeffry, the Roth IRA doesn’t get taxed during retirement and the Traditional IRA does, won’t I end up with more if I go with the Roth IRA?  Maybe, maybe not.

Typically folks that go into retirement tend to have less income, and less expenses (they have already paid off a mortgage, kids are grown up and gone, etc.).  So, assuming the tax bracket declined from 20% before retirement to 10% after retirement, the total after tax dollars you would have with the Traditional IRA would be $268,264.70.  The total after tax dollars you would have with the Roth IRA would only be $238,457.51.

That’s a difference of $29,807.19, quite a difference!

Most financial experts advise their clients to contribute to a Traditional IRA for this reason.  It usually turns out to be the better financial choice.  Of course, this is based on many assumptions, some of which may or may not turn out to be true.  If you would like to look at the worksheet behind all this, you may download it here:

Traditional IRA vs Roth IRA.xls

One thought on “Invest in a Traditional IRA or a Roth IRA?

  1. I offer a couple of caveats though. First, if you are young enough a Roth is the smarter choice because you will have saved so much money that you will be in fact in a higher tax bracket. I do not know where the breakpoint is. Second, if you are going to be maxing out contributions, max the Roth IRA first because you are infact getting more money working for you.

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