Roth IRA versus Traditional IRA
In this article I’m going to compare the Roth IRA with the traditional IRA to help you determine which is better for your situation.
With all of the options available to save for retirement, it can seem overwhelming trying to figure out how to invest. This article will discuss the basics of individual retirement arrangements (often called individual retirement accounts, or IRAs) and the difference between a traditional IRA and a Roth IRA. It will also explain which option might be best for you and how to choose what to invest in as well as how much to invest each month.
What is an IRA (individual retirement arrangement), also known as a traditional or regular IRA?
A traditional IRA (technically, an individual retirement arrangement, not an individual retirement account, as it is also often called) is a personal tax-advantaged account used to save for retirement. With a traditional or regular IRA, you are able to put money into retirement before paying taxes on it, thereby saving on the amount of income taxes you pay in the year you make the investment.
What is a Roth IRA?
A Roth IRA is a retirement account similar to a traditional IRA, but with a Roth IRA you pay income taxes on the money you invest now, but you are then able to pull the money out tax free in retirement.
Which retirement account is better—the traditional IRA or the Roth IRA?
When trying to determine whether a traditional or Roth IRA is better for your situation, there are a couple of things to consider. For younger investors (employees) and those who aren’t in the highest tax brackets who intend to save a good deal for retirement (which everyone should intend to do that! :)) so that they should be in a higher income tax bracket in retirement than they are now, the Roth IRA is generally the better option because you will pay less in taxes now than you would have to when you earn a higher income in retirement. Not to mention, given the current debt load of the United States government, it’s very possible that income tax rates will go up in the future in order to help pay for that overwhelming tax burden.
If you do not have a company-sponsored retirement account available to you such as a 401(k) or 403(b), you are better off in many cases to max out your Roth IRA (rather than investing in a traditional IRA) and then to invest in regular (non-tax-advantaged) accounts if that exhausts your tax-advantaged options. You are able to invest in either a Roth or a traditional IRA (or you could invest in both) a combined total of $5,500 each year (or $6,500 if you are over age 50).
So let’s look at an example. If you invest $450 a month in your Roth IRA in order to basically max it out (you could technically invest $458.33 a month), and you did that throughout your 35-year working career—from age 24 to age 59½ if you wanted to retire a little early, for example—and you received an average annual rate of return of 12 percent over that time (which is doable if you choose solid stock mutual funds with good track records), you would have $2,610,700, tax free. That means you wouldn’t have to pay income taxes on the money when you pull it out, so you effectively have at least 10 percent and up to as much as nearly 40 percent more of your money than you would otherwise. That tax savings is pretty sweet! Even though a million dollars isn’t what it used to be, you could struggle through on that amount. 🙂
Let’s say you love your job and love the idea of working a little longer more than you like the idea of retiring early, and so you choose to work 40 years—just five more years than in our original example above. Again, with an average 12 percent annual rate of return, that $450 a month for 40 years would grow to $4,639,368! Again, that money is all tax free! Can you even imagine having that much (tax-free) wealth? But it’s very doable; it doesn’t even require that much of a sacrifice.
And if you keep the money in good mutual funds earning an annual average rate of return of at least 10 percent throughout your retirement years, you could pull that much from your retirement account each year and never deplete the principal in your nest egg (the amount of money available in the account). So that $4 million would stay virtually intact and could be used as an amazing inheritance for your children and grandchildren, or it could go to some worthwhile causes to do some amazing good in the world.
Would you like some ideas on where to adjust your budget in order to find the $450 a month? Read this article with more than 35 ideas for how to reduce your spending in virtually all areas of your budget.
Once you begin investing for retirement, I recommend that you sign up for a great free app called Personal Capital in order to track your progress toward reaching your retirement and other financial goals. With Personal Capital, you can see not only all of your bank checking and savings accounts and even your credit cards and other finance accounts, but you can also link your retirement and regular nonretirement brokerage accounts. This allows you to have a complete, overall picture of your current financial situation. And you can also view your account history to see how your accounts and overall portfolio have done over time. I love this very helpful tool and use it regularly! Sign up for your free Personal Capital account here.
How much should I save for retirement?
Financial experts vary a little on how much they recommend individuals save toward retirement, but most of them recommend saving either 10 or 15 percent (or somewhere between the two) for retirement.
So if you make $40,000 per year, that’s about $3,333 per month, so you should save between $333 and $500 per month.
If you can (or as soon as you can), start saving 15 percent toward retirement to help ensure that you retire with dignity and in comfort. Because of the wonderful power of compound interest, the money you save now is the most powerful! So work to reduce your spending in other areas as soon as you can so that you are able to invest 15 percent of your gross income in good mutual funds as soon as possible.
Wish you could invest more for retirement? Learn ways to increase your income so that you can have more room in your budget to invest more toward reaching your retirement dreams!
How should I invest for retirement?
There are many ways that you can invest, such as buying stocks, buying real estate, and buying a business, but by far the easiest and least risky way to invest of these options is to invest in mutual funds. A mutual fund is a collection of assets that is professionally managed as a portfolio of investments. With a mutual fund you and many other people buy into the collection of assets, and so you “mutually fund” that portfolio of investments.
Mutual funds are made up of assets like cash, money market accounts, stocks, and bonds.
A money market account is a high-yield, high-minimum-deposit savings account.
A bond is where you buy the debt of a company or municipality, and they pay you back with interest.
A stock is where you buy a small piece of a publicly traded company, such as a technology company, automobile company, or food company. So, for example, you could buy a stock from Coca-Cola, Walmart, or Ford.
And stock mutual funds are mutual funds that are made up primarily of stocks.
When comparing cash, money market accounts, bonds, and stocks, long-term the asset that will make you the most money, based on past performance over many decades, are stocks. That is because they have more inherent risk than the other three options and therefore higher potential reward. However, mutual funds really aren’t that risky because you are investing in a wide variety of different companies, rather than buying stocks from a single company (that could go bankrupt, for example). Buying single stocks is what is really the risky venture, but investing in mutual funds is fairly safe as long as you are willing to keep your money invested long term. As one of my favorite financial experts says, you won’t get hurt on a roller coaster unless you jump off. I am a fairly risk averse person, but I am completely comfortable investing in mutual funds with good long-term (at least 10 years) track records, and you can be, too.
Which mutual funds should I invest in for retirement?
When you begin investing for retirement, invest in four main categories of mutual funds: large-company stocks, mid-size company stocks, small-company stocks, and international stocks. This will help ensure that you can benefit from the growth of all these different sectors and that you don’t lose all of your money when one of these sectors declines for a time. One of my favorite financial experts, Dave Ramsey, recommends a simple formula of investing 25 percent of your money for retirement in each of these areas. That’s what we have done for more than a decade now, and it has worked well for us (which is why I recommend it).
I know that when I started investing for retirement I really wished there was someone who had my best interests at heart (and not their commission rate) who would just hold my hand and show me the best funds to invest in and why. And that’s why I will email you and share with you exactly how we choose the mutual funds we invest in (for free—no strings attached) if you would like to enter your email address below.
When determining which is better, the traditional IRA or the Roth IRA, consider your own situation carefully. In many cases, especially for younger employees, the Roth IRA may be the better choice.
The Roth IRA is an excellent tool for investing for retirement. By investing consistently each month in your Roth IRA, you will be well on your way to building long-term wealth so that you can live in comfort throughout your retirement. By saving as much money as you can (a good rule of thumb is 15 percent of your income) as soon as you can, you will have much more money (because of the awesome power of compound interest) available to travel, take care of your medical needs, spoil grandchildren, give to causes you care deeply about, and more.
Are you ready to get serious about saving for your future? You can find more helpful information about investing for retirement here.
Want to Track Your Financial Progress?
Sign up for Personal Capital to be able to track how your investments as well as checking and savings accounts are doing and also view your account history to see how your accounts and overall portfolio have done over time. It’s a great tool! Sign up for your free Personal Capital account here.
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