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by Pastaman on June 5th, 2003

Pastaman

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Which is better, an IRA or a Roth IRA?

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Answers. 3 helpful answers below.

  • by Jackson Miller on April 25th, 2004

    Jackson Miller

    In addition to the other answers, I would only add one explanation:

    The Roth IRA and IRA conceptually both create a consumption tax system (as opposed to an income tax system), but they differ in the timing of their tax. Therefore, all other things being equal, from a purely tax-motivated perspective the IRA is better if your current tax rate is higher than your retirement tax rate. On the other hand, the Roth IRA is better if your current tax rate is lower than your retirement tax rate.

    An IRA works like a 401(k) plan -- a deduction from gross income is allowed for contributions -- that is, any money you invest in an IRA is not taxed to you currently as income. For example, if you have $10K income, but invest it all in an IRA, then you have taxable income of $0 and tax of $0. (But note Yoyo's answer concerning the availability of the deduction.) If you allow the $10K to grow at 8% interest, tax-free for 20 years, you will have $46.6K interest, providing a total withdraw in year 20 of $56.6K (i.e. the original $10K and the $46.6K of interest). However, you will pay tax on the full withdraw. If your tax rate is 28%, then you pay 15.8K tax & take-home $40.8. Notice especially that what does not matter is your tax rate when you earn the original $10K.

    The tax on the principal (e.g. the $10K) and on any interest it produces over the years is differed until the money is withdrawn (to be spent). Since the contribution is not taxed when it is earned, but rather when it is spent, the IRA converts the income tax into a consumption tax.

    A Roth IRA is funded with post-tax dollars -- that is, there is no deduction for contributions. But after you pay the tax currently on contributions to a Roth IRA, you have "consumed" the contribution & are not taxed on it or any interest it earns ever again. For example, if you have $10K income, you will be taxed on it at your current tax rate -- say, 28% -- paying $2.8K tax and leaving $7.2K to contribute to your Roth IRA. If you allow the $7.2K to grow at 8% interest, tax-free for 20 years, you will have $33.6K interest, providing a total withdraw in year 20 of $40.8K (i.e. the original $7.2K and the $33.6K of interest). When you withdraw the funds in year 20, there is no tax, providing the same "take-home" result in the Traditional IRA example above. Notice that what does not matter is your tax rate when you retire and withdraw the funds.

    If your current tax rate is higher (than your retirement rate), then it does not effect the traditional IRA at all, but in a Roth IRA, you will have less of your income to invest, providing a lower total return. On the other hand if your current tax rate is lower, then you will have more of your current income ot invest in the Roth IRA, providing a greater return. So this makes the decision easier: First, determine your expected tax rate on retirement. Second, determine the rate at which you contribution will be currently taxed. Then, pay the lower of the two rates.

    Your current tax rates might (and probably will) change over time, so it may be smart for you to have both a traditional and a Roth IRA. When you are a poor student (but wise enough to invest in your retirement early), you will have a very low (if any) tax rate, so a Roth IRA is a sure thing. If you are making the big money (but wise enough not to blow it on loose living), you will have a higher tax rate, so a traditional IRA (or a 401(k) plan) may pay-off.

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  • by Yoyo Head on March 13th, 2004

    Yoyo Head

    Neither the Traditional IRA nor the ROTH can be said to be better in general. They are different ways to go about retirement investing in a tax-advantaged way. The question of which is better depends on you and the particulars of your financial situation.

    If you participate in a 401(k) or 403(b) at your job, you are not allowed to deduct IRA contributions from your taxable income. If your contributions are not deductible, then a ROTH is the way to go because with a ROTH you don't deduct the contributions anyway. A ROTH has other advantages, like growing totally tax free, whereas with a Traditional IRA the earnings grow tax deferred, not tax free.

    Also with a ROTH it is easier to take money out early if you need to, although in my opinion you should never withdraw from or borrow against a retirement account unless it's a case of life or death, or maybe homelessness.

    This is a complicated issue so check with an expert who knows not only about IRAs, but who also knows you, and in whom you have confidence. If you don't know a person like that, find one.
    Good luck.

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  • by Santaanacanyon on July 11th, 2003

    Santaanacanyon

    ROTH.
    There are no penalties for early withdrawals.
    You only have to leave in whatever interest you have accrued up to that point.

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