Difference between a Roth and a Traditional IRA

**Traditional and Roth IRAs:**<br><br>**What is the difference?**<br><br>Difference between a Roth account and a traditional IRA is quite simple: Who pays the taxes.<br><br>**Roth IRA:**<br><br>* You contribute after you pay taxes on the money, so you don’t get a tax deduction when you contribute money to your IRA.<br>* In return, you do not have to pay taxes on the money when you are older.<br><br>**Traditional IRA:**<br><br>* You contribute before you pay taxes on the money, so you get a tax deduction when you contribute money if you are eligible.<br>* In return, you get your tax bill later: you'll have to pay taxes on the money when you withdraw it.<br><br>**Which is better?**<br><br>Well, it depends on your tax situation, or so you may think. It actually does not matter.<br><br>Let’s assume you have $1000 to put into an IRA.<br><br>If you put it in the Roth, you’ve paid the taxes already, and now you can put it into the IRA. If your tax rate is 25%, you will only have $750 to put into your IRA. But you will never have to pay taxes on that money again.<br><br>If you put it into the Traditional, you don’t pay your tax bill until you are older. If your tax rate is 25%, you now have a $1000 in your account, but you owe $250 in taxes. Until you pay those taxes, you only have $750.<br><br>Assuming you invest that money at the same rate, the Traditional account will grow because you have money to invest. But you still have a tax bill. If you don’t pay that tax bill now, it will still be there when the money grows. So you would have to pay taxes on the gains. And you still would only have $750 if you paid the tax bill now. But it doesn’t matter, because you don’t have $750 until you do pay the bill. <br><br>If you invest the $750 in the Roth, you will only have to pay taxes on any gains. So the only difference is that the Traditional has more money in it than the Roth. And that is because the Roth has already paid the taxes.<br><br>Let’s stop here and assume we have a time machine that can fast forward 30 years. The account in the Roth has $1000 in it because it earns 3% interest every year. The Traditional has $1050 because it has $1000 plus the $50 that it earns every year. But the Traditional account has a tax bill for $262.50. So it only has $787.50. <br><br>The difference between the two is only $212.50. The money that was invested if the original tax bill hadn’t been paid.<br><br>At this point, the Traditional account is getting pretty attractive. Who wouldn’t want to have $50 more than they currently do? But the Traditional account still has a tax bill. And it will always have a tax bill, until you pay the taxes. And at this point, the taxes have grown to $262.50. <br><br>But that is an easy tax bill to pay - it is only another 25% of the entire balance of your account. And now the account only has $775.50, which is still more than the $750 you put in your account. But now you’ve paid the taxes and can quit worrying about that bill.<br><br>The problem is that the tax rate isn’t 25% anymore. It is 33.33%. So now you only have $1000 - $775.50 = $224.50 to pay the taxes. You are paying $396.50 in taxes and you don’t have the money. You would have to withdraw money from your account to pay the taxes. It doesn’t matter what the balance is now, because you still have to withdraw the original tax bill amount. That may be more than your entire account now.<br><br>But this is only the tax bill you’ve accumulated on the original money you contributed. You still have to pay taxes on the gains. The account has grown to $1500. The account earns 3% interest every year, and that 3% comes out to $45 every year. So the total interest earned is $45 x 30 = $1350. <br><br>You would pay taxes on that $1350 at a 33.33% rate. $1350 x .33333 = $450. <br><br>$450 + $396.50 is $896.50 in taxes. And you don’t have that money. You don’t have that much in the account no matter how much it earns. So you don’t have enough to pay the taxes.<br><br>So if you invested the money in a Traditional account, you would have to withdraw money to pay the taxes. And you would have invested the money for 30 years. <br><br>**What has happened to the money?**<br><br>Let’s look at the money you didn’t put into a Traditional account. You kept the $250 tax bill you would have paid on the money, and invested it into a regular savings account. That account now has $1000 if it earns 3% per year. <br><br>That is $2000. That may not be enough to pay your taxes. But you have a cushion to help pay them. You do not have to withdraw the entire amount to pay the tax bill. And you may be able to get more money together. If there is a good job market, you could get a second job. If the economy is strong, you could sell something you don’t need. Or you could borrow some money from someone.<br><br>In any case, you are not stuck with the bill. And you still have to pay the taxes on the gains. So your Traditional IRA wouldn’t have enough money, no matter how much you put into it.<br><br>**What does this mean for you?**<br><br>So what does this mean for you? Well, you can try to save money by using a Traditional IRA account. You can put your money into one of these accounts and keep it there for 30 years. And in the end, you still won’t have enough money to pay your taxes. You will be paying taxes on any gains that account earns, and you will have to pay taxes on the original money. Which would have been free if you had just paid your taxes when you got your money.<br><br>On the other hand, you could put your money into a Roth IRA and keep it there for 30 years. And yes, you will pay taxes on the gains. But the original money you contributed is tax-free. So you will have that money to pay the taxes on the gains. And if you are older, you will have to pay taxes on the gains. If you are younger, you may be able to put the money into a Roth and pay taxes on the gains when you are older.<br><br>In other words, you can pay your taxes now if you are younger. Or you can pay your taxes now if you are older. Which one of those makes more sense? <br><br>You can:<br>* Pay your taxes when you are younger and put the money into a Roth.<br>* Or you can pay your taxes when you are older.<br><br>At this point, you have to give away all of your money or buy an annuity. You can’t put it into a Roth because you can’t get a tax deduction for a contribution from a retirement account. And you can’t put it into a deductible IRA.<br><br>So if you are older and you have money for a disability, you should put that money into a Roth. And you should invest that money and let it grow. And when you are retired, you will have a tax-free disability.<br><br>So if you are older and you have money for a disability, you can give that money away. Or you can buy an annuity. Or you can put it into a deductible account. But you can’t put it into a Roth. You will have to pay taxes on it, no matter what. So you should just put it into a Roth account. <br><br>So if you are older and you have money for a disability, you should invest the money and let it grow. And you should invest that money into a Roth account. And you should buy an annuity when you are retired. And then you will have a disability. And it wouldn’t matter if you paid taxes on it or not. Because you would still have to pay taxes on it. So you should just put it into a Roth account.