Whether you’re looking at options within your employer-provided retirement plan, or just opening up an Individual Retirement Account (IRA), the question of Roth vs. traditional will usually come up.
The concept of being able to contribute an amount to an IRA and pay taxes on it now instead of later was first proposed in the late 80s by two senators, Bob Packwood and William Roth, and finally legislated in 1997. A traditional IRA had existed prior to the Roth IRA, but was repealed in ‘86 and then re-established in ’97.
The main difference between Roth and traditional IRAs is simple:
|If you save money in....||Then you pay taxes on those contributions...||And at withdrawal, you pay taxes on...|
|a traditional IRA||Later||BOTH the contribution and the earnings|
|a Roth IRA||Now||NEITHER the contribution nor the earnings|
Let’s look at an example.
Bob has been saving $100/month into his traditional IRA since he was age 18. He’s now 60, retired, and needing to pull out money to live off of before he starts taking a Social Security benefit. Over the 42 years the money was invested, he averaged a return of 6%. Through compound interest, the account is now worth $227,016. He put in $50,400 in contributions, and the rest is investment earnings.
When Bob withdraws his money, ALL of the distribution will be taxable as ordinary income; it’ll be just like he’s sending himself a paycheck (minus having to pay other taxes associated with wage income).
Bill, Bob’s twin, on the other hand, saved $100/month into a Roth IRA for 42 years, averaging the same 6% return as his brother. His account is also worth $227,016, $50,400 of which is his monthly contributions and the rest of which is investment earnings.
When Bill withdraws his money, NONE of the distribution will be taxable as ordinary income, or even as a long-term capital gain – it’s COMPLETELY TAX FREE. Even though he withdrew $65,000 to live on that year, he has no taxable income as far as the IRS is concerned.
Since nothing can be exactly that simple with the government, there are several income and contribution limitations that come into play. However, a good rule of thumb if you’re just starting out with a job at 16 or right out of college barely making peanuts, start with a Roth account.Then you can switch to traditional later if your income becomes an issue or it would be more beneficial tax-ably speaking.