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29 April 2009

Investing Piggy BankWhich is better for investors today, a Traditional IRA or a Roth IRA? And if you're the investor, which option should you choose?

We're going to help you answer these questions today, but first, let's look at why you might choose one type of these Individual Retirement Accounts over the other.

A Traditional IRA allows individuals to direct a portion of their pretax income into an investment account that can grow without being subject to income, dividend or capital gains taxes while the funds are held within the account. Only when individuals withdraw money from their Traditional IRA does it then become subject to personal income taxes, but here, the withdrawals will be taxed at whatever income tax rates are in force when the money is withdrawn, not those for when the money is first invested.

A Roth IRA, on the other hand, works a bit differently. Here, individuals can contribute a portion of their annual income after they've paid income taxes on it into an investment account, whose balance can then grow over time without ever again being subject to income, dividend or capital gains taxes.

Assuming that the same investing options are available to both types of IRA, the advantage of one kind of account over the other comes down to how much you can expect to have to pay in income taxes, either at the future date when you withdraw funds from a Traditional IRA or when you first contribute funds to a Roth IRA. Here, for instance, if you expect that you'll have to pay higher taxes in retirement than you do today, then the Roth IRA might make more sense. But, if you expect that you'll have to pay a lower rate of taxes in the future, then investing in a Traditional IRA may be more to your advantage.

We've constructed the tool below to help you work out which type of IRA might be more suited to your needs. While it's set up to consider annual contributions to either type of IRA, you could also use it to decide whether it might be to your advantage to convert a Traditional IRA into a Roth IRA. Just enter the appropriate date into the fields below and we'll run the numbers for you!

Investment Data
Input Data Values
Amount of Pretax Income Available for Investing [$USD]
Average Annual Investment Rate of Return [%]
Time to Hold in Investment Before Withdrawal [Years]
Current Income Tax Rate Data
Your Current Federal Income Tax Bracket [%]
Your Current State Income Tax Bracket [%]
Future Income Tax Rate Data
Expected Future Federal Income Tax Bracket [%]
Your Current State Income Tax Bracket [%]

Calculated Investment and Tax Results
Calculated Results Traditional IRA Roth IRA
Combined Federal and State Income Taxes To Be Paid Before Investing [$USD]
Amount To Be Invested After Taxes Are Paid [$USD]
Expected Future Value of the Investment at Time of Withdrawal* [$USD]
Combined Federal and State Income Taxes To Be Paid at Time of Withdrawal [$USD]
Amount Remaining After Taxes Are Paid at Time of Withdrawal [$USD]
* We assume quarterly compounding applies for the invested amount for both the Traditional and Roth IRAs.

So now, the question comes down to how much you can expect to pay in taxes in the future. Right now, unless the current U.S. government acts otherwise, most income tax rates will be rising after 2010. The following table indicates how individuals in today's tax brackets may be affected:

Federal Income Tax Rates Planned Under Current Law (Current and After 2010)
Current Income Tax Rates 10.0% 15.0% 25.0% 28.0% 33.0% 35.0%
Income Tax Rates Beginning in 2011 15.0% 15.0% 28.0% 31.0% 36.0% 39.6%

And that's without even accounting for how much the government will be forced to increase income tax rates given the massive amounts of debt it is planning to accumulate beginning this year.

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