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While with a client the other week the topic of investing came up, specifically investing in Individual Retirement Arrangements (IRA). When discussing IRA’s, the question that is always brought up is what is the difference between a traditional IRA and a ROTH IRA? There are similarities between the two, most notably the contribution limit of $5,000 ($6,000 if over 50) in 2010. The main difference however is the tax treatment for contributions and withdrawals.
A traditional IRA offers tax deferred growth, meaning that all contributions are exempt from federal income taxes until the money is withdrawn. Where as with a ROTH IRA, all contributions are after-tax, meaning that contributions are taxed in the year they are made, however all growth is tax-free when you withdrawal it. You might wonder, what is the difference between being taxed now as opposed to being taxed later? The answer is potentially a whole lot of money.
If for 30 years you would put the $5,000 maximum contribution into an IRA averaging a 10% annual rate of return you would have ~ $942,000 at the end of the 30 years! That means you would have contributed $150,000 of your own money (30 x $5,000) and the rest of the ~$792,000 being compounded interest! With a traditional IRA the entire $942K would be taxed when you withdrew the money. But with the ROTH you would pay taxes on the $5,000 each year but the $942K would be tax-free when you withdrawal from the account! That is a difference of hundreds of thousands of dollars in taxes.
This is probably going to sound weird, but when it comes to retirement funding, please tax me now rather than later! As the above example illustrates, I prefer tax-free growth over tax deferred growth anytime of the week. By taking the tax hit today, you are sacrificing today to have more later.