by joeplemon on September 2, 2009
in Investing
photo credit: Kevin Krejci
Assuming you are investing for future retirement, you should seriously consider the Roth IRA (Individual Retirement Agreement). I am already a huge fan of the Roth, but as the national debt increases with federal bailouts and stimulus packages, the Roth IRA is looking better all of the time.
Let me explain. With the traditional IRA, you get to deduct the contribution for the tax year it was made, but you will pay taxes when you start drawing the money out for retirement. The Roth IRA, on the other hand, is purchased after you have paid your taxes and is therefore tax free when withdrawn. When deciding which one is best for you, conventional wisdom is that if you believe you will be in a lower tax bracket when you retire, you are better off with the traditional IRA. Why? Because you were able to claim a tax deduction at a higher percentage, but pay those taxes later at a lower percentage.
But I ask: do you seriously believe that the tax structure when you retire will be essentially the same as it is today? Is it possible that even if your retirement income is less than your working income, your tax rate could be higher than it is today?
Why The Roth IRA is a Good Choice
Our current national debt is $10 trillion and climbing by the second. My longhand math (calculators don’t have that many zeroes) indicates that we owe $30,000 for every man, woman and child in America. To compound the problem, the Social Security Trust Fund is scheduled for depletion in about 30 years unless “something” is done. That “something” will have to be raising taxes or lowering benefits. As I see it, Congress has four possible choices:
- We could spend less than we make. A great choice, but nowhere on the radar.
- We could print more money, but doing so will raise inflation rates, maybe to hyperinflation. Not a good choice.
- We could sell more Treasury Bonds, but our national debt is making these bonds more and more risky. Besides, neither families or nations can borrow their way out of debt.
- We can raise taxes. Again, not a good choice, but, in my mind, one that will happen.
Our future tax structure is very uncertain because of our national crash course with debt. Are higher income taxes a certainty? No, but in my thinking a very high probability. Although I am already retirement age, I invest in a Roth IRA every month. I just feel better about paying my taxes today, knowing that they are fully paid today and will never be impacted by future tax increases. That, for me, is a very good feeling.
photo credit: stuartpilbrow
You have come to the conclusion that you and you alone are responsible for your retirement. Good for you. You have decided to use an IRA (Individual Retirement Arrangement) as the vehicle to accomplish your goals. Good for you again. Now you are struggling with whether you should use the Traditional or the Roth IRA. Hopefully, this article will help you with this decision.
First some quick definitions on the rules of the Traditional IRA Account and Roth IRA Account:
While both plans are considered tax advantaged, they differ in how the taxes are handled. A Traditional IRA gives the contributor an IRS deduction for his annual contribution to the plan, but the retiree is required to pay income taxes when he accesses the money. With a Roth IRA, the contributor gets no tax deduction at the time of the contribution but pays no taxes when drawing the money out.
Because of these different tax treatments, conventional wisdom is that if you think you will be in a lower tax bracket upon retirement, you should choose the traditional IRA. Why? Because you would have received a deduction at a higher rate when contributing and paid the taxes back at a lower rate when receiving the money.
Roth IRA Vs. Traditional IRA Examined
To prove this point, let’s compare two people who make exactly the same salary and are both in a 20% tax bracket. Jill chooses to contribute $300 a month to a Roth IRA. Jack chooses to contribute an equitable amount to a Traditional IRA. This equitable amount will be $375 a month. How did I get $375? Because Jack is using a Traditional IRA, he will claim a 20% deduction of his contribution, which is $75. $375 – $75 = $300, which is Jill’s contribution. Are you with me so far? Another way to view this is that both make the same salary and, with this illustration, both will receive the same net pay after their contributions.
Assuming that both continue their contributions for 30 years and are able to get a 10% annual rate of return for the 30 year period, Jill would have a nest egg of $678,146 while Jack’s nest egg would be $847,683. Who did better? It depends on the tax rate Jack would have to pay when drawing his money down from his traditional IRA. If that tax rate is still 20%, we have a tie because $847,683 less 20% taxes equals $678,146…the exact same amount of Jill’s nest egg. Obviously, if Jack could get by paying less than 20% upon retirement, the traditional was the better plan; if he pays more than 20%, the Roth would have been the better choice.
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