Both a Traditional IRA and a Roth IRA provide tax advantages over an individual investment account. Using either plan allows you to grow your retirement fund faster. The one big difference between them is when you pay the federal income taxes due on the money you put into that account. As with a lot of things in life, the answer to the question of which account is better is, it depends. Or if you're in the mood for a little snark, the answer is, they both are.
What Happens When You Use a Traditional IRA
Incidentally, everyone, including the most knowledgeable financial advisors, call an IRA an "Individual Retirement Account." The IRS, however, says the name is "Individual Retirement Arrangement." Use either name, but if you use the IRS' official name, expect to be corrected!
A traditional IRA helps you grow your retirement funds faster by delaying the taxes that would have been due on the earnings you put into the IRA until you withdraw the money in retirement. This makes a big difference.
Here's an example: You're currently earning $2,500 a month. Your living expenses including estimated federal income taxes run about $2,200 a month, This leaves you $300 each month to put away for retirement.
Now do a little math jujitsu to figure out how much you could put away each month if you didn't have to pay taxes on the earnings you're putting into the IRA.
Here's how to figure that: $2,500 a month is $30,000 a year, which puts you square in the middle of the fed's 15 percent tax bracket for 2017. To put away that money, you had to earn a greater amount, which you can call X, to have $300 left after you've subtracted the 15 percent tax payment. In algebra talk that's X-.15X =$300
You can simplify the problem by getting rid of the X-.15X =300 way of looking at it and noting that this is the same thing as .85X. So .85X =$300.
Jumping all the way back to high-school algebra, you can solve for X by dividing both sides by .85. The result is: X equals $352.94. Round that to $353. That's how much you had to earn each month before taxes to have $300 available after taxes to put into your retirement fund.
If you always hated algebra and the calculation makes your head swim, you can have a handy little online algorithm do the work for you. It's on the Wyzant website included in the References. You can use it to calculate your own retirement using the actual amounts you plan to put away every month.
How much this extra $53 in the example matters is pretty surprising. If you're 27, you're going to be working for another 40 years to retire at 67. If you invest your retirement money in the stock market, you can use the 100-year average stock market return of nine percent per annum as the return on your own account over those 40 years. Plugging the info into an investment calculator like the one in the references, if you put away $300 each month for 40 years and the return is nine percent (compounded annually), at retirement you'll have $1,404,396.
But how much would you have if you'd invested $353 each month instead? Gong to the calculator again shows you'd have $1,652,506 – an additional quarter million dollars! That's the almost unbelievable difference it makes when you put your retirement money in a tax-advantaged IRA.
The Fly in the IRA Ointment
There is one drawback with an IRA, which is that eventually the IRS is going to make you pay taxes on the retirement fund you've accumulated – not all at once, but when you withdraw it. So, if in retirement you're planning to spend $50,000 every year, you'll have to pay whatever the tax rate may be on that amount when you withdraw it. While you're contemplating this unfortunate fact, remember that (at least in our example) you'll have over $1.6 million in the account, every cent of it is taxable the moment you withdraw it.
So far as the tax bite goes, however, the IRA's still a good deal because it allowed you to put more money into the account than you would have otherwise, which in turn (through the wonders of compounded gains) helped make that account grow much larger. But, it is something to keep in mind.
The Roth IRA Alternative
The alternative to an IRA is a Roth IRA, named after Senator William Roth, one of the original sponsors of the bill that enacted the plan. Like a regular IRA, it's a tax-advantage retirement savings plan. The big difference between the two plans is that with a Roth IRA you don't get an up-front tax deduction on the money you contribute. Instead, from then on, the money in the account is tax free. That's a big deal!
As with traditional IRA, regular contributions made over a long period of time, thanks to the power of a compounded return on your investment, end up being a whole lot of money.
Assume your monthly contributions to your Roth total $300 – this is the same amount as in the previous example, less the additional $53 you were able to put into the traditional IRA because or the tax break on IRA contributions. Per the previous example, at retirement you'll have $1,404,396. And every cent of it is tax free now and forever! That's the unique power of the Roth IRA.
Which is Better?
Determining which is better is a bit of an apples and oranges comparison. One big advantage to a Roth is that you can withdraw the money any time you want without a penalty and without paying taxes on the amount withdrawn. Early withdrawals from an IRA are both taxed and penalized.
On the other hand, if your career goes well, eventually you won't be able to continue contributing to a Roth, which has an annual income limit of $186,000. You get to keep what you've earned, of course, and the money in the Roth keeps on earning more money until you withdraw it, but if fortune smiles and you're earning more than $186,00 a year, you'll need to set up a traditional IRA for future contributions.
In general, some financial advisors, Schwab among them, favor a Roth for younger contributors, particularly if it's likely they will earn considerably more in the future. On the other hand, Money Magazine's tax expert warns "A Roth IRA Could Be a Worse Choice Than You Think," which is also the name of the article with the warning.
The tax code is a huge and complex beast and has hidden loopholes and penalties that can affect each taxpayer differently. The new tax code to be enacted in December 2017 promises to be even more complicated. Before deciding which version of IRA best suits your specific situation, you might be ahead in the long run paying for a consultation with a tax advisor.
One possible way of proceeding to keep costs down as you're beginning to invest might be to begin with the Roth, then revisit the situation with your tax advisor in a few years when you'll have a better idea of your earnings future.
The information provided in this article is accurate as of the date of writing, but it's designed to be a readable overview, not a deep dive into many details that have necessarily been omitted – for instance, at a certain age you're allowed to contribute a little more each year to your Roth, but that hasn't been included in the calculations provided.