Monday, February 3, 2014

Traditional IRA vs Roth IRA: part 2

Traditional IRA vs Roth IRA: part 2

By Keith Bunn Jr
February 3, 2014

Review From Last Week

Let's take a moment and briefly review what an IRA is.
An IRA means Individual Retirement Arrangement according the current tax codes. The IRA itself is NOT the investment. "IRA" tells the IRS how the investments inside the IRA are going to be treated. You have to have an earned income to contribute to an IRA, and are only allowed to have a maximum contribution of $5,500 ($6,500 if you're over 50) per year or up to you yearly income if you make under $5,500 per year. 

What is a Roth IRA?

The Roth IRA was named after Senator William Roth, who was a major advocate for IRA reform. So the Roth IRA was established as part of the Taxpayer Relief Act of 1997.
 IRA's and Roth IRA's are almost identical with a couple important differences. 

1) There are income limits: If you are married Filing jointly, making $188,000 per year or more. Or a single making $127,000 per year or more, you can not contribute to a Roth IRA.

2) Tax free growth: Unlike the traditional IRA, a Roth IRA is not taxed as you start taking the money at retirement. That's because you are taxed as you are putting the money into the Roth. That means the whole time you are contributing into a Roth and the investments start to grow, they are growing TAX FREE! That's a big deal! Because in all investments, it's not what we put into them that makes up the majority of the investment. It's the growth!

How Important is it Really?

Let's just say you couldn't put in the maximum contribution of $5,500 into either a traditional IRA, or a Roth IRA, but you could do half... $2,750. If you contribute that amount each year from the age 18 to 65 at a 10% rate of return, that would be $2,880,304.72. Not too shabby!

Now at current capital gains rates, if this was in a traditional IRA, that $2,880,304.72 would be taxed at 20%. Which means you would have lost over a half a million dollars in taxes, but in the Roth, you would have the whole $2,880,304.72.

Now here's the kicker... That whole time you were putting $2,750 into either the traditional IRA, or a Roth IRA, you only contributed $129,251.88. The rest, ($2,748,302.84) was growth. So this is a big deal. It is important!

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