Welcome to Part 3 of this series of posts. In Part 1, we introduced the concept of an IRA and defined the differences between a Traditional and a Roth. In Part 2, using an example by Charles Farrell from his book “Your Money Ratios: 8 Simple Tools for Financial Security at Every Stage in Life”, we found that fundamentally both types of funds are the same because they will both yield you the same amount of money after all is said and done. The real advantage is what you believe your tax situation will be later on in life.
However, I told you I would find the twist in this argument and I will present it to you now:
You Put Away More Money With the Roth:
“If the two funds are the same, why all the buzz about Roth IRA’s? Why do I always see them in headlines and magazine covers?”
There is one very innocent statement which holds the key to as to why a Roth beats a Traditional:
• You may contribute up to $5,000 per year to a Traditional or a Roth IRA
Stop right there! Let’s examine this statement a little more closely:
• The maximum amount you can put away each year into a Traditional fund is $5,000. Since taxes apply in the future (let’s say 25%), then that means you’re really only stashing away $3,750 after taxes (math: $5,000 x (1 – 0.25)).
• The maximum amount you can put away each year into a Roth fund is $5,000. Even though taxes apply now (let’s say 25%), you still get to stash the whole $5,000. That means you can really start off with $6,667 to put away (math: $5,000 / (1 – 0.25)) and lose $1,667 to taxes. But the $5,000 makes it to the fund.
This is a very important distinction! By choosing the Roth, you actually get to bank more money each year than with the Traditional! This is called your “effective” contribution rate.
Using our Example from Part 2, you can see how the Roth will eventually yield you more money and many more years until depletion.
But Wait! In Part 2, You Just Told Me They Were the Same?!
Yes I did, and they still are. The difference is that you get to start with a different contribution amount of money each year. Let me illustrate this point:
• In last example in Part 2, we assumed you only had a fixed amount of money to contribute ($2,000). That means you can put away $2,000 now and pay $500 in taxes later (plus taxes on the gains), or put away $2,000 – $500 = $1,500 now and pay no taxes later (including the gains). Since this is well below the $5,000 threshold, everything works out the same.
• In this latest example, we took our contribution all the way up to the limit. Let’s go extreme and say you had $10,000 to put aside. No matter what, you can only put $5,000 into the Traditional which will eventually only yield $3,750 in the future after taxes. But with the Roth, you can put aside $6,667 only to have $5,000 make it into the fund after taxes.
In other words, pre-tax, you can either contribute $5,000 to a Traditional fund or $6,667 to a Roth fund. If you’re looking to maximize how much money you can put away, then the Roth is the better deal!
Isn’t That Still the Same Thing? With the Roth, I’d Still Be Paying Taxes Now!!
Yes you are and it is very important to remember that fact. Just because you “effectively” get to contribute more to the Roth doesn’t make the tax situation seem any better.
But let me ask you this: Let’s continue to assume your tax rate will be the same now and in the future. When you’re 65 years old, are you going to want to pay taxes? You’re going to wish you had taken care of business and paid up when you were younger. It’s a lot easier to make sacrifices on expenses when you’re younger because you can always recoup. But when you’re older, it will be a lot harder to recoup those expenses and give your money up to tax costs.
Summary of Why I Like the Roth:
In summary, here is why the Roth has my vote:
1) I want to maximize my tax-sheltered savings. As explained above, the Roth allows me to put more money away each year pre-taxes.
2) I’m hoping to be richer when I’m older than I am now. Therefore, I’ll likely be in a higher tax bracket. As shown in the second example in Part 2, choosing the Roth and paying taxes now while I’m in a lower tax bracket would be the better choice.
3) With a Roth, you are allowed to withdrawal your principal contribution without penalty after 5 years of investment. This is very important in case there was ever an emergency and I really needed the money. With a Traditional, you are not allowed to ever withdrawal your principal contributions without penalty until you reach the age of 59½. Although I skimmed over this fact in Part 1, this is a very important consideration in emergency planning.
These are my opinions on why I think the Roth is the better option between the two choices. Some of the material covered got pretty abstract. If anything was unclear, please share a comment below. Also, if there is anyone out there who has significant reasons why the Traditional IRA might be the better option, I also invite you to post your comment in the field below.