Remember back when you were a child and your parents said you couldn’t do something and it made you really really want to do it? Well, that’s how many people approach the Roth IRA because after you start making more than $95,000 the amount you can contribute to a Roth decreases. Once you earn more than $110,000 per year, you can no longer contribute $4,000 (in 2006-7) towards your Roth.
Well, just because you can’t do something is no real reason why you should do it when you can, let me go into the reasons why you should do it.
Diversification
By diversification, I mean diversification from a tax perspective. Most employees will have the option of participating in a tax-deferred retirement plan, a 401k or 403b or something like that, where you can contribute and deduct the contributions from your income. Since we won’t know what the tax rates will be when you retire, you want to have a portion of your retirement assets free from tax – that’s where the Roth IRA comes in.
Earnings Grow Tax Free
When you contribute to a Traditional IRA, you get to start with a bigger amount but that amount is taxed when you withdraw it from the account. With the Roth IRA, it “costs” more to contribute that $4,000, because you are using money that has already been subject to income tax, but all of the earnings are tax free.
Comments
5 responses to “Roth IRA or Traditional IRA?”
That’s a great observation that a $4,000 contribution to a Roth IRA “costs more” than a Traditional IRA. While I’ve always understood the pre-tax vs after-tax considerations, I never thought about the contribution limit itself in terms of pre-tax earnings. At a 30% combined fed & state income tax rate (both now and in retirement), the Roth IRA contribution limit is equivalent to about $5,700 pre-tax. That’s 42% more money that you can sock away than with the Traditional IRA!
Weekly Roundup – 01/26/07…
Here’s a quick look at some articles that caught my eye over the past week:
JLP talked about retirement risks.
Jim talked about when frugality is a fault.
Flexo is having trouble with his TIAA-CREF SEP-IRA.
FMF talked about the best place to sa…
[…] My Retirement Blog gives us Roth IRA or Traditional IRA? Come by and explore the various IRA vehicles available to you. -ooOoo- […]
The best analogy I have ever heard comparing traditional vs. Roth IRAs is…Would you rather pay taxes on the seed or the harvest? In other words, would you rather pay taxes on money now when you don’t have that much (Roth is after-tax money), or pay taxes later upon withdrawal (Traditional IRAs are deductible, or pre-tax, and are taxed upon withdrawal – as are 401ks).
Excellent points. Your contributions actually cost more than $4k, but if invested properly, will return a lot more than that over the long run.
I think you bring up another good point by saying “do it while you can.” Of course, I would love to make more than $115k, but I don’t. So why not plan now, then alter the plan once my income increases. It’s not like they’ll take the money I saved away. Plus, if you open your roth ira retirement account at a reputable bank, it will help you build a customer relationship with that institution. Hey, every little bit counts.
Again, excellent tips, and keep it up!