Every now and then I get asked whether or not someone should put their money into an IRA or a Roth IRA. There seems to be confusion as to which would be more appropriate. The argument in favor of IRA’s & 401(k) is that you can defer paying the tax on the money you currently earn reducing your present tax liability. The drawback is that you will eventually have to pay the taxes and can not escape them. In retirement, this may cause additional taxes on your Social Security income if your taxable income is too high.
Roth IRA’s and Roth 401(k)’s are my personal favorite for people to put their money. You use the after tax money from this years earnings to contribute in, but the money grows tax free for the rest of your life! Where this is most beneficial is when you are younger and have a much longer period of compounding growth. For example, if you are 30 years old and have managed to save $100k in a Roth IRA, your money will double 3 or 4 times by age 65-70 with average market growth. 100k becomes 200k becomes 400k becomes 800k becomes 1.6 million. That’s a 1.5 million dollar growth TAX FREE! Now imagine that same growth was in an IRA. You would then be subject to full taxation on the money and lose potentially 750k or more in taxes as a result.
Ultimately what is this about? It’s about retirement income. Tax Free money means double the amount of retained income you get to keep. If you have 1.6 million in retirement, that would provide roughly $8k a month in income. If it’s an IRA, you’re looking at more like $5-6k a month in income.
What I find with Roth IRA and Roth 401(k) is freedom in retirement.