Albert Einstein referred to compound interest as “the greatest mathematical discovery of all time.” However, earning compounding interest in a tax-free environment is even better. Individual Retirement Accounts (IRAs) were created to give Americans an incentive to save for retirement by combining the benefits of compounding interest with a favorable tax status.
While both traditional and Roth IRAs allow investments to grow tax-free, they differ in their tax treatment. Your particular circumstances will determine which IRA is most tax-efficient for you. But in many cases, a Roth IRA offers some of the biggest tax advantages. So, how do you know which IRA to choose?
The Traditional IRA
As long as you (or your spouse) receive a paycheck, you are eligible to open a traditional IRA. And, depending on the size of your paycheck, your contributions may even be tax deductible. All contributions to an IRA grow tax-free, allowing you to take full advantage of compounding interest year after year. However, when it comes time to take a withdrawal, you’ll pay taxes on the money withdrawn – the vast majority of which may be earnings.
For example, T.J. opens an IRA and makes a tax-deductible contribution of $1,000. After ten years he retires and decides to drain the entire account. His initial investment has grown to $10,000. Because T.J. owns a traditional IRA, he must pay taxes on the full withdrawal amount of $10,000.
If you are tempted to postpone withdrawals from your IRA to avoid paying the taxes, think again. Soon after your 70th birthday, all IRA owners must begin their Required Minimum Distributions. A traditional IRA will not let you enjoy the tax-free earnings forever.
Whether you are hoping to fund a traditional IRA or Roth IRA, caps on yearly contributions are the same. Account owners may contribute $4,000 per year in 2006 and 2007. Contribution limits rise to $5,000 in 2008. Thereafter, contribution limits will increase in $500 increments, indexed to inflation. All account owners 50 and over are permitted an additional “catch up” contribution of $1,000 per year.
In order to get money back out of your IRA without incurring a penalty, you must be 59 1/2 or older. A handful of special circumstances will permit you to take early withdrawals. However, all non-qualified distributions will be subject to a 10% penalty in addition to any federal and state income tax.
The Roth IRA
The Roth IRA bears some similarities to its counterpart. Like the traditional IRA, contributions grow tax-free. But the defining difference of the beloved Roth IRA is in the way funds are taxed, or – better said – not taxed. While all contributions to a Roth IRA are made with after-tax dollars, the growth on the account is not subject to taxation. When funds are withdrawn, neither the contribution nor the earnings are taxed. That’s right. All the growth in the account is tax-exempt, not just tax-deferred as with the traditional IRA.
Let’s assume that, this time, T.J. decides to open a Roth IRA. He funds his Roth with an after-tax payment of $1,000. Ten years later, he decides to drain the entire account. Again, T.J.’s initial investment has grown to $10,000. But this time, with a Roth, he can withdraw all the funds, tax-free.
And if that wasn’t enough, Roth IRAs do not force you to begin required minimum distributions at age 70 1/2. This difference is an effective planning strategy. Because there are no required distributions from a Roth, it should always be the last tax-qualified dollars to be used in retirement. You are best to leave your Roth investments untouched and happily compounding.
While the face value of two IRAs may be the same, the taxes owed on traditional IRAs may dramatically reduce the actual amount you bring home. Sometimes it is clearer to plan ahead by looking behind. Remember back in the ’50s and ’60s when the top marginal tax brackets were close to 90 percent? In comparison, today’s top tax bracket of 35 percent is a deal. Historically, income taxes have not been this low since 1931. Now is a good time to move money into a Roth. Tax rates are probably going to increase, not decrease.
Making the right choice between a traditional IRA and Roth IRA is not always clear. Changing tax laws, your current tax bracket, your current and expected income, and how long you have until retirement are important factors in the formula. The foresight of an experienced professional can help you plan ahead. To find a fee-only financial planner in your area, visit www.napfa.org.
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