Monday, August 11, 2008

The LD on IRA's

My deepest apologies for not making a legitimate post in the last few weeks. Last night I was at a bar with a few friends and the topic of IRA's came up. A friend of mine had just opened a traditional IRA and didn't know the difference between what he had opened and a Roth. There is a BIG difference...

IRA = Individual Retirement Account

Traditional IRA - A traditional IRA is like any other account you would open at a bank or brokerage that allows you to invest your money with the exception that it is earmarked for the individuals retirement. The largest and most important detail to know about the traditional IRA is that ALL deposits are made with PRE-TAX dollars. Thus, you can itemize your contributions to your traditional IRA and do not have to pay taxes on the contribution. HOWEVER, when you retire (after age 59.5) any withdrawals made from the account are taxed at the rate corresponding with your most recent income.

EXAMPLE - You graduate from college (age 22) and your salary is $30,000 thus falling into the 15% tax bracket. You contribute $4,000 a year with pretax dollars. When you decide to retire at age 62, your salary is now $100,000 placing you in the 28% tax bracket. You have accumulated approximately $350,000 in your traditional IRA and when you withdraw it, you will be taxed 28%-35% and your retirement nest egg will be squandered to $240,000 by the federal government. (In layman's terms: this sucks.)

Roth IRA - For the sake of simplicity, the Roth works exactly like a traditional IRA with the EXCEPTION OF HOW THE FUNDS ARE TAXED. With a Roth, you make contributions to the account with AFTER-TAX dollars. At retirement, you can withdraw the entire balance of the account TAX-FREE.

EXAMPLE - You graduate from college (age 22) and your salary is $30,000 thus falling into the 15% tax bracket. You contribute $4,000 a year with post-tax dollars (so about $3,400). When you decide to retire at age 62, your salary is now $100,000 placing you in the 28% tax bracket. You have accumulated approximately $300,000 in your traditional IRA and when you withdraw it, you will pay NO TAXES on the balance. The federal government has already taken their cut, but it was when you were paying about HALF THE TAXES. (In layman's terms: this is a beautiful thing.)

Retirement Funds with traditional IRA - $240,000
Retirement Funds with a Roth IRA - $300,000
Net Gain - $60,000

Keep in mind this is an extremely basic explanation. The lesson to extrapolate from this post is if you are younger than 30, and still have many years to reach your salary ceiling, a Roth IRA is a RIDICULOUSLY good opportunity. The example above remains very simple, the difference between the two accounts could potentially be more than $500,000 depending on your income.

Go to your bank. Go to your broker. Open a Roth IRA.
(and don't pay a yearly maintenance fee)

3 comments:

Dominick said...

a man of his word... good.


thanks for the post.


i am now wondering the benefits of the traditional IRA due to compounding. This seemingly measly 40$ that will be taken out of my contributions (from the roth example) will be worth much more through a future value calculation.

if i was able to maintain a 6% return on my funds... what would the 40$ extra per year that I would be contributing becuase of the tax benefits of the traditional IRA be valued at 40 years from now? I can;t find my financial calculator to do the calculation.

Devlin said...

I like the way you think.

If you stick with the traditional, that $40 you save per year by itemizing the contribution will become about $6,200. This is found by finding the future value (FV) of an annuity. $40 per year, for 40 years, at 6%. (I'll write a post on the time value of money)

While $6,200 is no amount to be scoffed at, it is chump change when held in comparison to the massive difference you receive when taking advantage of the tax sheltered Roth.

Also, the interest rate I used in my examples was about 4% which is so low it is almost ludicrous. (I have a 3.69% savings account.)

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