“Should I be funding a Roth IRA or a traditional IRA?” - This question comes up often in social gatherings that I have been a part of, and is always an interesting debate. The answer is obvious to anyone who knows what the tax code and their tax rate will look like at retirement. If you expect your tax rate to be higher at retirement, you are better off paying taxes now and putting money in a Roth IRA. On the other hand, if you expect the tax rate to be lower at retirement, then you are better off taking the tax break now.
However most 30 something folks like me do not have a crystal ball. We have no clue on when we will retire, let aside, what our tax bracket will be when we retire. Also we have no idea how the congress will change the tax code in the next 20-30 years when we approach our golden years. So, for my planning purposes, I have stopped trying to predict these changes. I assume that the tax rate will be the same when I retire as it is now. That lets me remove one variable and lets me focus on how I can maximize the size of my retirement nest.
Interestingly, there seems to be no consensus on whether the Roth IRA or the traditional IRA is a better saving vehicle. I had done a math earlier in a spreadsheet and found the Roth to be a better savings vehicle for me:
Roth effectively lets me contribute more towards a tax sheltered account than an IRA would let me. The limits for both the Roth IRA and traditional IRA (and for that matter Roth 401K and traditional 401K) are exactly the same. However since the Roth contribution is after tax, effectively, you can stash more money away into your retirement account than with a traditional IRA. You will come out ahead just because you put more money in there to begin with. If you have the extra cash to stash away while you are young, compounding growth can provide significant tail wind to your retirement investments in the future.
Roth IRA lets you withdraw your contributions (not the earnings on the contributions) penalty-free, after 5 years, so you have access to your money for unforeseen things that may come up.
If you fall behind in college savings for your kids and are ahead in your retirement savings, you can always use Roth to fund your kid’s higher education.
Roth ensures tax-free income when you retire.
However I should point out, that if you are like some people that I have talked to, who are not contributing to either Roth or traditional IRA because you are trying to decide which one to set up, doing either one is certainly better than making no contributions. Remember you have until April 15, 2008 to make IRA contributions for the 2007 tax year.
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4 comments:
Very timely! Any thoughts on the SEP-IRA?
Very interesting.
Samir,
A SEP stands for a simplified Employee Pension. If you are self employed or if you have a company with a few employees, you can contribute to the retirement accounts. This works similar to a traditional IRA EXCEPT that the limits are higher. The rules for a SEP IRA contribution are as follows:
1. You can contribute upto the maximum of 25% of the earned income of an individual or $45,000 in 2007.
2. You have to follow the same rule for all US employees (so you cannot discriminate)
25% - wow! Thanks for the info...
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