IRAs Made Simple!


Understanding The Difference between The Traditional IRA and The Roth IRA


Many across the web are publishing posts today about Roth IRAs.  These posts will be written by people with brilliant financial minds.  They will likely give you more information than you could ever need about IRAs.  And you will be a much better educated person as a result of readng them.  By all means, read these posts - they will surely be very good and well worth your time!

But how many bloggers out there will write a simple, easy to understand post about these two IRA options?  That is what I am going to try to do...  explain the difference between the Traditional IRA and the Roth IRA in as simple of a format as possible and by using as few words as possible.  After all, your time is valuable.  So let's begin....

What is an IRA?
An IRA is an acronym for Individual Retirement Account.  Basically, it is a retirement savings account that you initiate on your own much like a SIPP pension in the UK (unlike a 401K that is employer initiated).  While you have to pay taxes on the pay you actually put in to the IRA (either when you put it in or when you take it out... more on that later), your money is allowed to grow tax free!  Because of that, having an IRA is an excellent strategy to help ensure financial security when you retire.  There are two main types of IRAs - Traditional and Roth. 

Traditional IRA
The Traditional IRA works like this: you put money into your IRA tax free. That means, you do not have to pay income tax on any money you deposit into an IRA... yet.   It is allowed to grow tax free.  When you reach retirement age and begin to withdraw your money, you must pay taxes on what you initially put in (but not the growth). 

Roth IRA
The Roth IRA works like this: you put money into your IRA and pay taxes on it just like all your other income. It is allowed to grow tax free.  When you reach retirement age and begin to withdraw your money, you get all your money completely tax free!

Huh?  So what's the difference?
Good question.  The difference (for this simplified version) is when you pay taxes on the money used to fund your investment.  Either you pay upfront or you pay when you collect.  The benefit to delaying paying the taxes (Traditional IRA) is, of course, instant gratification in lowering your tax bill when you invest in an IRA.  The benefit of paying your taxes upfront (Roth IRA) is that no matter how much money you are earning in retirement and no matter how much the tax laws change (after all, taxes seem to always be on the rise... do you really think that will be changing anytime soon?), you have already paid your dues.  You are not going to get hit with a huge tax bill because of the IRA at a time in your life where your income may be less than you have been used to.  And if you have planned well for retirement, you won't have to pay a big tax bill on the IRA if your earnings push you into a higher tax bracket!


All things considered, I think the Roth IRA is the best option to consider for most investors.  How about you?  DO you have any IRs?  if so, what kind and why?

12 comments:

WorkSaveLive said...

We have Roth IRAs and I'm certainly a big fan of them for no other reason then the one you explained: all of the money in there 30 years from now is ALL MINE! Regardless of how bad of shape our country gets in and regardless of how high the taxes go, I have already been taxed and they can't touch any of my earnings! Cha-ching!

Karunesh @ chase-a-dream.com said...

I would choose the option of paying my taxes now. Thanks for sharing :)

John@MoneyPrinciple said...

Ah - now I understand. In the UK conventional pension funds are like your 401K's in that they are linked to the employer although we can't withdraw from them until 55.

In some cases the pension paid was a fraction of your final salary before retirement times the number of qualifying years. This particularly benefitted people who were promoted later in life, or promoted themselves if they became managers or something.

With people moving jobs etc it became quite difficult to do this because the fund had to be valued or you got lots of little pensions. In addition, aided by some silly legislation, some unscrupulous employers dipped into the pension fund when it became a bit fat - or not fat at all. As a result employers have to value their pension funds every year and, although the liability is spread over many years to come, this gets in some way subsumed into the total company valuation by the market (it's wrong to do that of course).

Now employers are moving to an individual fund which is built up and more portable. This particularly discriminates against women and does not generate employee loyalty either. The excuse is that pension funds are depleted because of the stock market but the reason is that we live longer than when the pension system was introduced.

Then there are pension plans which sound like your IRAs - you pay into them before tax and are taxed later on. Which is fine (a) assuming you live to draw a pension and (b) assuming your pension is less than your salary so you get tax relief at a possibly higher rate and pay tax at a lower rate.

Otherwise I don't think we have an equivalent to a Roth IRA - this just seems to be a high-yield savings plan.

Every country has different systems for what are essentially the same problem - even across the European Union there are many countries where the (often enormous) public sector is completely unfunded which makes it difficult when we hit the rocks!

Thanks for the explanation!

Admin JH said...

I have both. I generally think Roth IRA's make the most sense since I expect to be in a higher tax bracket later in life, and tax rates usually go up. Therefore I will probably pay more tax on the money later. I have a regular IRA because of an old 401k that I rolled over. I plan on changing it to a Roth and paying the taxes on it, but need to do so slowly so I can afford all the taxes!

SB @ FPR said...

Great to see you joining Roth IRA movement

Kari@ Small Budget Big Dreams said...

I don't have a Roth yet, but plan to start one as soon as we get all our of "one time" house buying expenses out of the way and get settled into our mortgage payments.

Shortroadto said...

The only concern I have is 3 decades from now, when the social security fund is dry, the government changes the law and taxes the Roths. It is a long shot but it can happen. Here is a post I did for the Roth IRA movement.
http://shortroadtoretirement.com/2012/03/the-roth-ira-movement.html

Kurt @ Money Counselor said...

Roth vs. Traditional is partly a philosophical question. I kinda like getting my tax benefit now--the traditional IRA--on the 'bird in the hand' theory. But I surely understand the mathematics probably supports the Roth for most people. If only I trusted the government more... :-)

CultOfMoney said...

In general, I'm a fan of fully funding your traditional IRA first, because given the same amount of starting dollars, the traditional gets you a larger amount in time because the amount paid in taxes with a roth is getting the benefits of compounding in a traditional IRA.

BrilliantFinances.com said...

Correction, you said regarding the traditional IRA "When you reach retirement age and begin to withdraw your money, you must pay taxes on what you initially put in (but not the growth)" that’s not actually accurate. For a traditional IRA you are taxed on withdrawals for what you put in (contributions) and the earnings (growth) , but if you made non-deductible contributions you will be taxed on the earnings but not on the contributions.
Sorry I don’t usually go around making corrections to blogs, but this could make people make a very bad decision if they are trying to choose which IRA is best for them.

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