No. of Recommendations: 1
>> ..you'll owe maybe $644. If you're in the 15%, $345. I'd pay that in a second and consider it a downpayment on a million TAX FREE dollars.

I think thats over simplifying it. The tax you pay now no longer factors into the compounding part of the equation. People often compare a $2000 Tradition IRA to a $2000 Roth IRA contribution, but, as you pointed out, the Roth contribution will cost you more in taxes. To my figuring the tax upon withdrawal for the traditional IRA (that has compounded on the unpaid tax in the beginning) is exactly the same as the upfront tax for the Roth. Now I know equations make everyones head swim but these aren't too dificult.

Traditional IRA:
s=p*(1+i)^n*(1-r)
This states that value,s (what you get) equals principle times the quantity 1 plus interest (assummed returns, dividends, capital gains, etc.; most pick between 8 and 12%) raised to the power n (number of years invested) (so far this is simple compound interest, stick with me) times the quantity 1 minus the tax rate (to acount for taxes paid at retirement).

OK, lets compare to a Roth:
s=p*(1-r)*(1+i)^n
Here you've paid taxes up front so to compare apples to apples you're investing less. Then compound that amount. If you look closely these equations are identical.

The difference is that for the Roth your taxed at the current rate, for the Traditional IRA the tax rate is whatever it will be at retirement. Some believe taxes will go up. History has certainly shown us this. But you must also consider that you will have less income in retirement (typically you can live comfortably with 80% of your final income, and if you've paid off your mortgage, quite a bit less) so a traditional IRA is better.

Why then all the ballyhoo regarding the Roth? Because the Roth contribution is after tax and the limits for both IRA types are set at $2000, the Roth essentially allows a gross up contribution of ~$3000 depending on your current tax rate (this number comes from $2000/(1-r) assumming r is 33% (28% fed + 5% state)) (the p in the above equation). In essence, the Roth allows a larger annual contribution limit.

The other reason the Roth gets so much press is the limits for participation are set much higher, allowing more high income people to participate.

Doug
Print the post  

Announcements

The Retirement Investing Board
This is the board for all discussions related to Investing for and during retirement. To keep the board relevant and Foolish to everyone, please avoid making any posts pertaining to political partisanship. Fool on and Retire on!
What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Community Home
Speak Your Mind, Start Your Blog, Rate Your Stocks

Community Team Fools - who are those TMF's?
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.
Advertisement