If you are fortunate enough to have enough spare cash to save for retirement, you may not know where to put it. Hopefully I will clear this up a little bit for you in this post. First of all, if your employer has a 401k program where they match your contributions, you should almost always contribute to that first. If you still have more to invest after that, you should probably invest your money in an IRA (individual retirement account). Both IRAs and 401ks have tax benefits that make them much better investments over regular, taxable accounts.
What’s the difference between Roth and Traditional?
Traditional IRA– Deposits into a traditional IRA are tax deductible. This means that you don’t have to pay taxes on any money that you contribute to the IRA. If you used money from your paycheck that you already paid income taxes on, you will get a refund at the end of the year when you file your taxes. Also, your deposits will grow tax free, and you will not pay taxes on them until you withdraw them in retirement.
ex: Let’s say you made $50,000 during the year, and you put $3,000 of it into a traditional IRA. You would pay income tax on only $47,000. Your deposit will grow tax free until retirement, then you will pay taxes on it as you take it out in the form of ordinary income tax.
Roth IRA: With Roth IRAs, your contributions are not tax deductible. This would mean you have to use money that you have already paid income taxes on to fund your account. Just like the traditional, the Roth IRA will grow tax free. The benefit of having a Roth is that you can withdraw from the account in retirement tax free.
ex: Let’s say you still make $50,000/yr. You will still have to pay taxes on all 50k. The good news is that your $3,000 deposit will grow over the years and when you take it out, you will not have to pay taxes on it. All the money sitting in the Roth IRA is yours, the tax man won’t take any of it if you are in retirement.
Which one will give me more money in retirement?
If all things are equal, meaning you stay in the same tax bracket your whole life and contribute the same amount to either account, then it makes no difference which account you put your money in. I will do an example in a minute so you can see what I mean, but the gist of it is in the rare, unlikely chance that everything stays the same, both accounts will have the same value after taxes at retirement. This almost never happens so for most people, you need to figure out which one is best for you.
ex: To simplify things, I am going to assume that you deposited $1,000 into an IRA and that you earned 5% return on this deposit for 5 years before retirement and we will calculate how much you have in the account after taxes in retirement. Also we will assume a 10% tax rate.
Traditional: With traditional, you will pay your taxes at the end. This is where the .90 came from (10% tax). The 1.05 is the 5% interest each year for 5 years.
$1,000 x 1.05 x 1.05 x 1.05 x 1.05 x 1.05 x .90 = $1148.65
Roth: With a Roth, you pay taxes initially, this is why I multiplied by .90 at the beginning instead of the end.
$1,000 x .90 x 1.05 x 1.05 x 1.05 x 1.05 x 1.05 = $1148.65
As you can see you end up with the same amount of money after taxes in both accounts. Most people don’t stay in the same tax bracket their whole lives don’t only have $1,000 to contribute. These factors make a difference when it comes to choosing the right IRA.
Which one is right for me?
This depends on 2 factors:
1- Whether your tax bracket will be higher or lower in retirement.
2- How much money you have to invest
1) If you are going to be in a higher tax bracket in retirement, then the Roth IRA is better. This is because you will have already paid your taxes back when you were working and in the lower tax bracket. Most people are in a lower tax bracket in retirement since people usually spend as much money once they are retired. This would mean that Traditional would be the better route.
2) If you can afford to max out your IRA, then the Roth is better. This is because you can put more money in a Roth than in an IRA. Yes, the limit for both is $5,000 but with the Roth, you are essentially putting in more money because you already paid taxes on it. So if you already paid your 10% its like you deposited $5,555.56 while in a Traditional, you could only deposite $5,000.
Hope this cleared things up a little bit for people. I know it was long but maybe now you know where to put your money. If I confused anybody even more, contact me or comment and I will try to explain things for you.