I decided to write a post on this, because I realized last month that some people are still on the fence about it. Specifically, my boyfriend, who just got hired on by Apple Inc., was trying to decide what type of retirement plan to set up when he asked me to explain the difference between the Roth IRA and the traditional Individual Retirement Account. You may have heard that each type of account works best for certain individuals: namely, the traditional works best for older, high income people who will benefit from the tax reduction and the Roth works best for young people, who do not have a high tax rate to begin with... But there's more! It's not black and white
Either way you're going to have to pay taxes on the money you're putting away. It's just a matter of deciding when. For young people OR people making under about $75,000 it would not be that beneficial to be contributing to a traditional account, because the tax difference is not that big. It may seem big right now, because you're paying it. But, think about when you're retired and have no more earned income AND you have to pay taxes to use your retirement savings. That sounds worse to me. Plus, your tax rate will most likely be higher then, then when you put the money in initially. I mean let's hope by the time you retire you'll be in a higher tax rate than when you started your career, right?!
You don't have to choose
I would say why not have one of each? If you rely on the tax savings currently, and could not face paying more taxes, I understand. But could you start a separate Roth IRA (there's a $5000/year limit anyway) and start contributing to that as well? That way you will have a bunch of money available to you, tax free, when you retire. This is especially great for stay-at-home spouses, who may be depending solely on their partner for retirement savings. Starting a Roth for yourself is perfectly acceptable and a great way of protecting yourself.
Other benefits
Besides the tax issue there are other reasons Roth IRAs, specifically, are cool.
- no penalty to take the money out early if you have good reason. Those reasons are:
- buying a house
- medical emergency
- no penalty to take your principal contributions out, penalties only apply to money you earned from interest
- protected funds from most public benefits programs (will not count towards your asset limits), but you would have to check each one individually
- safe place to practice investing - well as safe as investing can be! But at least you won't have to deal with tax issues around capital gains/losses.
If you have basic questions regarding Roth IRAs such as who is eligible, when you can take the money out, what type of Roth you want, etc. check out this useful overview: You Need A Budget - Roth IRA
I'll follow up on this, with some extra tips on Roth IRAs once this is digested. =)
