Most people get confused about the different ways to save for retirement. What’s the difference between a 401k and an IRA? Should I open a Roth IRA or a “Traditional” (aka Regular) IRA?
When you’re confused, it’s easy to let inertia take over and do nothing. That’s a bad decision (and doing nothing is a decision) because the biggest money advantage you have, is TIME. The more time your money has to grow, the faster you build wealth. Your money earns money all by itself, through interest and growth. That’s the magic of compound interest.
So let’s clear up the Roth vs. Regular IRA haze.
What’s the difference?
The difference is when you pay taxes on your deposits into the account: now or later.
Let’s say you’re contributing to an IRA through your employer.
With a Roth IRA, your Federal, State and FICA taxes are deducted from your contribution. So, if you planned to contribute $250 a month and you’re in the 22% tax bracket, $195 would be deposited into your Roth IRA. ($250 minus 22% in taxes = $195.) In other words, you pay taxes on your account now.
With a Regular IRA, your contribution is made before any taxes are withheld. So the full $250 gets deposited into your account. It’s not quite as good as it sounds, though: You’ll pay taxes on your account later, when you’re in retirement.
Won’t the Regular IRA grow faster?
You might be wondering, isn’t it better to contribute a larger amount each month? $250 vs $195 a month makes a big difference over 30 years.
That’s true:
$250 x 12 months x 30 years = $90,000 in the Regular IRA.
$195 x 12 months x 30 years = $70, 200 in the Roth IRA.
That’s a difference of $19,800 in contributions!
But remember: You haven’t paid taxes yet on the $90,000 in your Regular IRA. Let’s say you’re still in the same 22% tax bracket when you retire: What’s $90,000 minus 22%?
$70, 200: The exact same amount you’d have contributed to a Roth IRA.
So they’re they both the same in the end?
Fine, you say, so it makes no difference which type of IRA you choose because at the end of the day, they’re exactly the same?
No. They’re exactly the same ONLY if you’re still in the same tax bracket when you reach retirement age as you are today. If you believe your tax bracket will be higher when you retire, then it makes more sense to invest in a Roth IRA. Why? Because you’ll pay taxes at today’s tax rate – 22% in our example – and will owe no more taxes on the account. That’s a bargain if you retire in the 36% tax bracket. You basically “prepaid” your taxes at a lower rate. Had you contributed to a Regular IRA, taxes would be charged at the tax rate you’re in when you retire and start taking money out: 36%.
The flip side may also be true. Let’s say you’re in a high-paying consulting job earning significant income today. Your plan is to work like crazy now, earn a lot of money, and then become a teacher in 10 years. Or work part time as you head into retirement so you can pursue a hobby. If your tax bracket is higher now than you expect it to be when you retire, it makes sense to delay paying taxes on your IRA. Choose the traditional IRA and you may owe only 22% in taxes later, vs the 36% rate you’d pay today.
To decide which IRA makes more sense, ask one question
“When do I think I’ll be earning more money (i.e., in a higher tax bracket)? Now, or later in retirement?
If later, open a Roth.
If now, open a Regular.
No one has a crystal ball, so your guess may be wrong. Don’t let that lure you into inertia. The most important move is to start contributing now.
A few other things to consider
If you’re unsure whether your income will go up or down later in life, remember — if you’re in the same tax bracket, it’s a wash. Taxes will be the same either way.
You can also open both: Start with a Roth and open a Regular later, or vice versa.
The Roth allows for more flexibility than the Traditional IRA. For example, if you run into money challenges later on and want to withdraw some of the contributions you’ve made, you can do that with no penalty or taxes (because you’ve already paid the taxes.) If you need to withdraw contributions from a Traditional IRA, you’ll owe taxes at whatever rate you’re currently paying, and you’ll also pay a 10% penalty to the IRS if you withdraw money before age 59-1/2.
You can contribute to either a Roth or Regular IRA on your own, if you’re not covered by a plan at work. But keep in mind, if you ARE covered by a plan at work and choose to also contribute to a Regular IRA outside of that plan, there are limits to how much of your contributions can be deducted on your taxes. That’s not an issue with a Roth.
Here are the key takeaways
- If you think you’ll earn more money later than you are today, open a Roth IRA. If you’re earning more today than you expect you will in retirement, open a Regular IRA.
- Either way, don’t delay. Open an account. Time is your biggest advantage, by far.