When talking with people about investments, I’m a bit surprised at how many people aren’t sure what the differences are between a Roth IRA and a regular IRA.
For those of you who aren’t sure, let’s take a quick look at how they function. These differences can make a big impact on your standard of living in the future.
When you put money into a regular IRA, you get an immediate tax advantage. Let’s say you put $5,000 into your IRA this year. You can now take a $5,000 deduction on your 2011 income taxes. That’s a good thing, right?
Well, yes. But is it your best choice?
You have to look into the future to see what happens when you take money out of your IRA. Let’s say you use our services here at MoveTheDecimal, and your $5,000 grows to $50,000. To make this simple, let’s say you take the entire $50,000 out in one lump sum. Because you got a federal (and state) tax break for investing in your IRA, you will have to pay taxes on the entire withdrawal. If your federal tax rate is 28%, and your state tax rate is 10%, that’s 38% of your money going to taxes. In dollar terms, that’s $19,000 you’ll have to pay in taxes. Ouch! All you’ll have left of your $50,000 is $31,000.
Now let’s see what happens if you put your money in a Roth IRA instead of a regular IRA. Let’s assume you put the same $5,000 into a Roth IRA.
First the bad news. You don’t get an immediate tax deduction. When you complete your taxes next year, you won’t be able to deduct $5,000 from your income. That means you’ll have to shell out $1,900 more in taxes than if you had put your money in a regular IRA (assuming the same 38% federal and 10% state tax brackets) .
But let’s look into the future when you take your money out of your Roth IRA. (Just because it’s a Roth IRA doesn’t mean it can’t be invested exactly like a regular IRA). Again, let’s say your $5,000 grows to $50,000, and you take the entire $50,000 out in one lump sum.
Because you paid your taxes up front, there are no taxes due at withdrawal. The entire $50,000 is yours to spend as you wish.
Which One Makes the Most Sense?
So the question is, would you rather use a Roth IRA, and pay $1,900 in taxes now, or use a regular IRA, and pay$19,000 in the future? Seems like the Roth IRA is the logical choice.
Technically speaking, they are both exactly the same. I’ve used an Excel spreadsheet to prove to myself that paying the taxes now vs paying them in the future is exactly the same. In other words, if you use the Roth IRA, and pay the $1,900 now, that money could have been invested. And if it grew at the same rate, it would grow to $19,000. That’s the same amount you would pay in taxes had you had used a regular IRA!
So if they both work exactly the same, is there really any advantage to using one over the other? The short answer is YES!
Here’s Why I Recommend Using the Roth IRA Instead of a Regular IRA:
First, looking back on my experience of helping retirees with their finances, one of their chief concerns is reducing taxes in retirement. When people get to retirement age, they tend to invest more conservatively. If they have a modest retirement account (401k, IRA, Roth IRA, etc.), they will probably have to pull money out just to pay the bills, pay for their health care, and make ends meet. That means that if they have to pay taxes on every dollar they pull out, it hurts them even more.
So psychologically speaking, if you can feel more at ease in retirement by not having to worry about paying taxes on your withdrawals, the Roth IRA wins hands down.
Secondly, imagine that you have a fairly significant sum of money put away. The example we often use here at MoveTheDecimal is $100,000. If you had used our Stock Market Timing System from 2007 – 2010, your account could total over $1.2 Million. Wouldn’t you like that account to be completely tax free? Otherwise, Uncle Sam is going to have his hand out when you start taking money out of your account. I’m sure he’ll thank you very much for doing such a good job of investing for him. In essence, he’s your silent investment partner, sharing in your gains and losses.
Third, if you use a regular IRA, the government REQUIRES you to begin taking withdrawals in the year after turning 70 and a half. Think of it this way: because the government gave you a “tax break” up front, allowing you to deduct your contribution, they want to get their money back, with interest. With a Roth IRA, because you paid your taxes up front, there is no requirement to take withdrawals, at any age.
Finally, and most importantly, is the issue of future tax rates. If you are paying any attention to what is happening here in the U.S. and around the world, you are seeing governments everywhere slashing spending and raising taxes to keep themselves from going bankrupt. If taxes go up in the future, the Roth IRA is by far the superior vehicle to use.
Prepare Yourself Now for the Future
I believe there is a very high probability that we are going to see basic services slashed, and taxes raised at the Federal, State, and local levels. I’ve studied the history of tax rates, and know that we’ve had Federal tax rates as high as 70%.
From what I’m seeing on the news, there are more and more people unemployed, under-employed and completely given up looking for work. The government must give them handouts for them to survive. U.S. corporations have shipped most of our jobs overseas and shuttered our factories in order to increase their profits. The U.S. government has done nothing to stem the tide.
There are very few jobs to be had, which means the working class is having to support more and more of the unemployed. One in seven Americans are now on food stamps. Illegal aliens pour into our country and demand that the government feed them, house them, and give them free health care and education for their children. The list could go on and on.
As our country slips more and more towards a socialist state, there are millions of people who are angry at anyone who is successful and making money. “It’s not fair!” they scream. “Why should they have money, when there are so many other people in need!”
I predict that not only will taxes go dramatically higher in the future, but also that the APPEARANCE of having wealth will draw criticism from future society. Having money in the bank and being self sufficient will not only be socially taboo, but could one day become dangerous, as angry, hungry, unemployed mobs look to take their frustrations out on people who appear to be “wealthy”. “Take from the rich and give to the poor” will become the norm, even if it means using physical force to do so.
If taxes do go dramatically higher in the future, as I predict, there is no question that the Roth IRA is the logical choice over a regular IRA. Pay your taxes now at these historically low rates. You’ll want to avoid the massive tax rates we’re likely to see in the future.
To your success,