Traditional versus Roth IRA or 401(k)
In this article I’m going to explain the difference between the traditional IRA and Roth IRA and help you know how you might decide which is better for your financial situation.
With all of the options available to save for retirement, it can seem overwhelming trying to figure out how best to invest. This article will explain the differences between a traditional and Roth IRA (or traditional 401(k) and Roth 401(k); the way that the two types of funds are tax advantaged is similar).
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, so you do not receive any tax savings at the time that you invest the money for retirement, as you do with a traditional IRA. However, you are then able to pull the money out tax free in retirement, which can be a huge advantage depending on your current and projected financial circumstances.
Which retirement account is better—the traditional IRA or 401(k) or the Roth IRA or 401(k)?
Once you understand the difference between a traditional and Roth IRA, then it is time to decide which type of retirement account is better for you.
When trying to determine whether a traditional or Roth IRA (or 401(k)) 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. This is because you will pay less in taxes now than you would have to when you earn a higher income in retirement.
In addition, 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 we have in the United States.
If you do not have a company-sponsored retirement account available to you such as a 401(k) or 403(b), you may be better off in many cases to first 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).
The Roth IRA: An Example Scenario
So let’s look at an example. If you invest $450 a month in a 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 probably struggle through on that amount. 🙂
An Even Cooler Scenario
Let’s say that 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 (10 percent) 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 21 ideas for how to reduce your spending in virtually all areas of your budget.
A Helpful Personal Finance App
Once you begin investing for retirement, consider signing 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.
I hope that you feel you understand better now the traditional versus the Roth IRA.
When determining which is better, the traditional versus the Roth IRA, consider your own situation carefully. In many cases, especially for younger employees, the Roth IRA may be the better choice. Read this article for more information about the traditional IRA and the Roth IRA and which retirement account might be better for you.
Both the traditional and the Roth IRA can be an excellent tool for investing for retirement. By investing consistently each month in your 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.
Which type of retirement account, traditional or Roth, are you investing in? Or which type of account do you think would be best for your particular financial situation? I would love to hear your opinion! Leave a comment below and let me know!
Invitation to Share
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