What is a Roth IRA and How IRAs and Roth IRAs Can Work For You

Posted on 16 July 2011

What is a Roth IRA and How IRAs and Roth IRAs Can Work For You: Twenty or thirty years ago, retirement used to be a taboo thing to save for. After all, you worked your life at a company, they gave you a pension, and that’s what you lived off of when you retired. However, pensions are a thing pretty much of the past at this point, as employers are looking to cut costs. Yes, it is going to require your own money for retirement now, especially with Social Security Administration potentially being bankrupted in as soon as a decade from now. However, there are definitely devices that can work for your for retirement and help you save money, and today, we’re going to explain the difference between a traditional IRA and a Roth IRA and how each of these methods can work for you!

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First off, we should answer the question about what an IRA is. In an IRA, you put money away for your retirement into investments such as bonds and funds, and whatever money you contributed you would get a tax write off for. In other words, if you made $50,000 and contributed $5,000 into a traditional IRA, you would have a taxable income of $45,000.

It sounds like a great plan, and for many, it is. After all, for as long as you have that money in your IRA, it continues to grow via interest and dividends, and you never pay taxes on any of that money until you use it. The bad news though, is that you can’t touch that money without a 10% penalty (plus the income tax) until you turn 59.5, and once you turn 70.5, you have forced distributions that will add to your income level.

Relatively recently, Uncle Sam created the ability to use a Roth IRA, which allows you to put money away for your retirement with a different tax structure. Under a Roth IRA, you can contribute money that you have already paid taxes on, but the dividends and interest that that money earns is never taxable to you and you can withdraw the money any time after five years that it has been invested without any penalties.

On traditional IRAs and Roth IRAs, you are limited in 2011 to contributing $5,000, or $6,000 if you’re over the age of 50. There is significantly discussion in Congress about raising these limits in the years to come, potentially by an incredible amount to give the Average Joe more of an ability to save for his retirement.

The question whether the Roth IRA or the Traditional IRA is the right investment tool for you comes down to the time value of money. Generally speaking, the lower your tax bracket, the more likely that you are to want to invest in a Roth IRA.

If you are single and have made less than $8,500 in income this year but would like to put away $5,000 into a Roth IRA, you’d owe absolutely nothing in taxes at any point in your life on that money, including the dividends and interest that the $5,000 makes. Anything less than $16,500 worth of income, you’re only paying a 10% tax on that money, whereas if you are in the next tax bracket beyond that, making $83,600 or more, or are going to owe 25% or 28% on that money that you invest in the Roth IRA. Of course, you’ll never pay taxes when you withdraw that money either.

On the flip side, the higher your income, the more likely you are to want to hang on to that tax money right now. The theory of the traditional IRA is that you are avoiding paying taxes now when you’re making money and paying less in taxes when you withdraw that money later on. Of course, we never know what tax laws are going to look like at that point when you retire, so we are playing a tad bit of Russian Roulette from that standpoint. However, just in the time value of money, if we can save 28% of $5,000, that’s $1,400 that we have access to until we turn 70.5 that Uncle Sam doesn’t have.

The other note about retirement vehicles is that you have to start as early as possible to maximize your money. Again, we’re talking about the time value of money here. If you start investing $5,000 per year at the age of 30 at a reasonable 5% annual rate of growth, you’ll have $671K at the age of 70. If you start at 35 though, you’re only going to have $503K at 70.

Regardless of whether you utilize a Roth IRA or a traditional IRA, make sure that you’re putting money away for those golden days now, and you’ll be sure to be able to live out your retirement years in style!

Please leave a comment below as we are always interested in hearing feedback on our articles or even other tips and advice we forgot to mention that you have used to make more money by growing your personal assets.

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