Individual Retirement Accounts: the hype and the sweet lowdown

Here's a tax take-home for all y'all:

So, the hype is that Roth IRAs are way better than traditional IRAs.

Here's the lowdown. Traditional IRAs and Roth IRAs are economically equivalent. With traditional IRAs, your contributions are deductible, but you get taxed on everything you take out when you retire. With Roth IRAs, your contributions are not deductible, but you don't get taxed on anything, including the interest, that you take out when you retire. So it might seem that you're getting taxed more on the traditional IRA because you're getting taxed on the interest. But this is wrong, because, theoretically, the deduction that you get when you make the traditional IRA contributions will allow you to invest income in early years that you might otherwise have had to pay in taxes. So, my sources tell me, the amount that you get to invest (plus the interest you make on it) now b/c you get the traditional IRA deduction exactly equals the taxes you save from not getting taxed on the interest on the Roth IRA.

However, this relies on several assumptions. It assumes that your tax bracket will be the same both now and when you retire. This is apparently unlikely--often people's tax brackets go up (at least if they work a lot) in retirement, in which case it might be better to get the Roth IRA because you'll pay the tax now at the lower rate. The reverse is also true--if you think your tax bracket will go down, then better to get the traditional. (For that reason, if your tax bracket shifts around a lot, it might be good to get both, and contribute to the Roth when you're in a low tax year and a traditional when you're in a high tax year.) It also assumes that you'll invest the amount you save with the traditional IRA deduction. And it assumes that the interest rate you get on the Roth IRA contributions will be the same as the interest rate you get with the investments you make with the amount you save from the traditional IRA. Finally, it assumes that you have enough income to offset with the deductions. If you're not making more than the personal exemption plus the standard deduction, you won't pay any income tax, so the deduction isn't worth anything to you.

Also, there are some rules that make the Roth more attractive than the traditional. The Roth IRA is a lot more flexible about when you get to take money out without penalties, so if you wanted to use the money for a down payment on a house, you might be able to without paying any early-distribution penalties. Traditional IRAs also limit how you take your distribution: you have to start getting minimum distributions after you turn 70.5 years old. There are probably a few other differences, but those are the main ones.

This, of course, is not tax or legal advice. Everyone should consult someone (else, who is) qualified before making these kinds of decisions.



(Props to Rob and the boy on the bike)

. . .