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Whenever I meet clients, I can safely assume that they are confused between Traditional and Roth IRA. Actually, most of the times it’s safe to assume that they wouldn’t know the difference between the two. Generally speaking, a Traditional IRA is where before-tax dollars are contributed (which, at time of withdrawal, are subjected to tax) whereas a Roth IRA is funded with after tax dollars (and hence aren’t subjected to tax at the time of withdrawal).

Since Traditional IRA is an approach taken with an employer sponsored plan, it allows the employee/investor to invest more money over the life of the IRA. This is what makes the plan more lucrative in actual practice even though Roth IRA may have sounded more impressive initially. Here is an interesting example I found.

If an investor/employee invests for 30 years for an 8% return in Traditional IRA, he will accumulate approximately $300,000 if he has been investing $200/month. On the other hand, if we assume a 20% tax, the Roth investment will be $160/month (after tax) which will accumulate to approximately $240,000.

Obviously, one will still need to pay taxes on the Traditional IRA. Normally, for retired people, the tax bracket reduces from 20% to 10 % (since they have already paid their mortgages, have less income, and other such factors). Hence, after withdrawal, the money from Traditional IRA will be approximately $270,000. This is almost $30,000 more than Roth IRA.

It is for this reason that most experts advise to contribute to a Traditional IRA. Even though it is based on many assumptions, it usually turns out to be the better financial choice. Since these assumptions may not be true for everyone, it really depends on every individual’s situation.

Filed under: Finance, Financial Planning, Investing, Personal Finance, Taxes, Understanding Finances