The late former Sen. William Roth (R-DE) co-authored the 1981 Kemp-Roth tax cuts. Included in that bill was the creation of Roth IRA. The bill allowed a person with an individual retirement account to invest their taxable income so that it could be withdrawn tax-free in retirement.
Traditional IRA vs. Roth IRA
When you compare the two types of IRAs side-by-side, the differences become apparent. A traditional IRA allows you to deduct the money you invest against the taxes you paid. A Roth IRA uses money that has already been taxed and, because of this, your contribution cannot be taxed again. The money contributed to the plan, called the principle, is yours to withdraw at anytime although I would strongly suggest against doing so.
The earnings in a Roth IRA grow tax-free as well. When the plan is available for distribution at 59 12, all of the earnings you have made on the contributions are tax-free. Not so with a traditional IRA. The earnings and the contributions are taxed at your current (retirement) rate when you begin distributions between age 59 12 and 70 12.
Some Caveats
The differences between the two types of IRAs do not stop there. In a Roth IRA, a qualified distribution can be made after five years. This non-taxable event allows you to withdraw up to $10,000 per person a couple can withdraw $20,000 for the purchase of a first home or to rebuild. You may also withdraw money to help a family member with their first home.
A Roth IRA can be an excellent way for young parents to save for their childrenıs college. You may not even have kids at this age and if you do, thinking about college for them might lead you to make a bad choice: your retirement or your kidıs college. Choose retirement.
In a Roth IRA, you can save money for your retirement. The money saved in a Roth IRA can be used for your childıs college education. It is better to save the money for their education in a 529 plan or a Cloverdell but if those savings plans fall short and you do not want your child burdened with college loans, use can use some of the money in your Roth IRA to help offset those costs. Use his feature as a last resort. Keep in mind, you cannot borrow money for your retirement. Focus on your future first.
And although the contributions are yours and you can withdraw them, try not to. Keep that money working for you. But if you need the money, unlike a 401(k) loan, you do not need to pay it back nor will you be penalized. You will, however lose the earning potential that money had but it will not cost you otherwise. However, tap the earnings before 59 1/2 and you will be subject to all of the penalties a traditional IRA withdraw before that age. You will be taxed at your current income tax rate and pay a 10% penalty for the withdrawal.
Income Limits
Roth IRAs come with some income limits that make it more difficult for wage earners later in life to use these types of accounts. You may contribute $4,000 to these accounts in 2008 (if you are older that 50, you can contribute $5,000). But you may only do so as long as your income falls below $101,000 if you're single, and $159,000 if you're married filing a joint tax return.
At that point, the contribution limit is phased out. This means that once your income begins to rise, your ability to contribute to a Roth IRA declines incrementally. By the time you hit the $116,000 mark (single) or $169,000 level (married and filing joint returns), your contributions must stop.
Keep in mind, any money already contributed can stay where it is, you just cannot add to the account. This makes the Roth IRA even more important for younger investors to use and use now.
Counting the Differences
Letıs do some basic comparisons. We will make the same contributions to both funds, assume annual compounding and regular investments on a monthly basis. We will also use the same $4,000 contribution limits ($4,000 divided by 12 = $333).
We will also assume you are twenty with a forty year horizon. The last assumption and the most unpredictable is inflation. With any luck, it will be at 3% when you retire. But that is only a guess.
| Roth IRAs vs a Taxable Account |
| Input |
0 balance | 0 balance |
| 8% savings | 8% savings |
| $333 | $333 |
| 40 years | 40 years |
| 0 tax rate (Fed) | 25% tax rate |
| 0 tax rate (state) | 6% tax rate |
| 3% inflation | 3% inflation |
| $489,269 | $270,829 |
If you have a company-sponsored plan that allows you to save money in a tax-deferred account, do it is well. Having a Roth IRA has no affect on that type of plan because the money you put in a Roth IRA has already been taxed. Use your companyıs plan in addition to your Roth IRA, especially if your employer offers some sort of a matching contribution.
Because this is best used for retirement accounts of younger investors, be more aggressive with the mutual funds you pick.
Opening an IRA is generally less expensive. Many mutual fund families lower the initial deposit for retirement savers. Many also allow you to make deposits online as well.
Some Quick Tips On Picking a Fund
- Look for a fund that has done better than its peers over a three to five year period. Avoid top ten lists of less time.
- Look for a fund manager that has been with the fund at least three to five years
- Look for a fund that has low expenses at least a third less than their peer group
- Look for lower turnover. This refers to the amount of times a portfolio changes in a given year. Turnover of 100% means the portfolio has changed once in a given year. A portfolio turnover ratio of 50% means the mutual fund has held on to its stocks for at least a year and half. A turnover ration of 150% means the manager is frequently selling the portfolio holding stocks less than six months.
- Look for no-load funds. Loads refer to the money you have to pay up front (front-loaded) or when you sell the fund (closed-end). A no-load fund puts the money you invest right to work.
Additional FAQs about defined contribution plans.
Additional Reading
At what Age?
Mutual Funds
Retiring with a Plan
