Roth IRA and Traditional IRA Tax Implications in Plain English

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When deciding between a Roth IRA and a Traditional IRA and the tax implications, you just need to remember one little fact.  You will pay taxes on that money.  The only questions are: when and how.

There are other differences, like the IRA withdrawal rules, contribution limits, and income limits, but that is another post for another time.  In this article, we are going to focus on clearly explaining the tax implications of the Roth and Traditional IRA.

When you start your retirement planning, one of the first decisions you will need to make is which retirement account suits you best.

Roth IRA and Taxes Explained

With a Roth IRA, income tax is paid up front, and you do not pay taxes on gains.

If you put $5,000 into a Roth, you will still be required to pay income tax on the $5,000.

Thus, if you invest in a Roth IRA, you will not receive any tax benefit this year just because you invested in a Roth.

If, when you retire, the account is worth $75,000, you do not pay any more income tax; nor do you pay any taxes on the gains.  You keep all $75,000 because you have already paid your taxes when the contributions went into the account.

Tax Summary: Income tax is paid at the front end when you make contributions, and it is not subject to capital gains.

Traditional IRA Tax Lessons

With a Traditional IRA, income tax is paid at withdrawal, and there are no taxes on gains.  This is called a tax deferred investment.  You defer your taxes to a later date.

If you put $5,000 in a Traditional IRA, you don’t pay any taxes on that money today – it is tax deferred.

If you put in $5,000 in 2010 then you would pay tax on $5,000 less dollars this year.

However, a Traditional IRA will be subject to income tax when it is withdrawn.  If your account is worth $75,000 at retirement and you withdraw $75,000, you will pay income tax on $75,000.  You will not, on the other hand, pay any capital gains taxes.

Tax Summary: Income tax is deferred until you take the money out, and it is not subject to capital gains.

Roth IRA is like McDonald’s and the Traditional IRA is like Applebee’s.

Sometimes a little analogy makes everything clear.

When you go to McDonald’s or Applebee’s, you must pay for your food.  When you invest in either, you must pay taxes.

At McDonald’s, you pay when you order the food (payment is up front).  When you invest in a Roth, you pay taxes when you put money into the account.

At Applebee’s, you pay when you are done eating and heading out the door (payment is deferred).  When you invest in a Traditional, you pay when you withdraw the money.

Compare the Roth IRA and the Traditional IRA: Which is Better?

There is not one investment vehicle which is inherently better for everyone, so (unfortunately) you’ll need to do a little retirement planning.

Two Questions to Answer When Deciding Which is Best – a Roth or Traditional?

What is your current tax bracket and what do you expect your bracket to be at retirement?

Let’s assume you are a younger person just getting started in the work force and you are in the 15% bracket.  You anticipate, however, that in the future you will be paid more money so you will likely jump up to the 25% bracket.  Furthermore, you anticipate taking out enough money at retirement that you would be in the 25% bracket.  In this case, you are better off using a Roth IRA because you are only paying 15% on the money.  You will probably not be in this low tax bracket again.

The biggest factor of all … will tax rates be higher or lower when you retire?

Let’s assume you are paying 15% taxes today, and in 30 years when you retire the government decides you will only need to pay 5% in taxes.  Well, if you used a Roth IRA, you’re going to feel bad because you paid 15% on that money when you put it in.  However, if you used a Traditional IRA, you’re going to be happy because now you pay 5% instead of the 15%.

FYI, in my opinion, tax rates will likely be higher in the future.  Based on what?  Nothing other than my gut feeling.  That is why I invest in Roth IRAs.

Not feeling particularly confident about your prediction?  You could just take the safe road and invest in both a Roth IRA and a Traditional IRA.

Which investment would you suggest: Roth IRA or Traditional IRA?

Comments

  1. says

    Craig, I dig your analogy between the Roth and Traditional IRA using McDonald’s and Applebee’s. Very creative!

    I would suggest a Roth for its tax-free withdrawals, and as a spin on the Tradtional IRA, I would suggest a 401k if you have one at work. The 401k has similar tax treatment to the Traditional IRA in that you get a deduction now, but pay later when you withdraw. However, the contribution limit for the 401k is a lot higher than an IRA ($16,500 vs. $5,000 in 2010).

    Furthermore, you can contribute to BOTH in the same year. Coverage under a 401k plan at work doesn’t affect your ability to contribute to a Roth. So you could contribute up to a total of $21,500 this year towards your retirement if your income is within the Roth IRA income limit. In the case of the Roth and Traditional IRA, you can also contribute to both, but you can only contribute a combined total of $5,000 to both accounts.

    Even though we may think that tax rates will increase in the future, we can’t be totally sure. By investing in both, we can take the safe road just like you said. This way, we’re controlling everything in our power and not worrying about everything else.
    .-= Darren´s last blog ..Unique Code =-.

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