What’s the Difference Between a Roth IRA vs. a Traditional IRA?

What’s the difference between a Roth IRA vs a traditional IRA? I could explain it in one sentence:

With a Roth IRA, you tax the seed. With a traditional IRA, you tax the tree.

All right, there you have it. Do you get it? Let me explain a little bit more.

With a Roth IRA, you contribute after-tax money. So, if I have taxable income of $50,000 and put $4,000 into my Roth, I still pay taxes on $50,000.

With a traditional IRA, your contribution is pre-tax. With my $50,000 taxable income, if I put $4,000 into my traditional IRA, I’ll pay taxes on just $46,0000 ($50,000-$4,000).

Ok, now let’s get an actual investment going. Let’s say I can afford to invest $5,000 this year.

If I want to tax the seed (with the Roth IRA), I’m left with $3,750 after paying taxes on that $5,000 (at a tax rate of 25%). If I wanted to skip the seed tax for now and choose a traditional IRA, I could invest the full $5,000 – because I’m not taxing the seed – I’m going to tax the tree later on.

“Echo to base. The seed has been planted.” And now let’s say we contribute this $5,000 before/after tax each year to our investment. We do this faithfully for 30 years. Let’s also assume we get a conservative 6% return on our investment for both the Roth and traditional IRA. Here’s what our nest egg would’ve grown to given these assumptions:

Nest Egg After 30 Years:

• Roth IRA: $335,794
• Traditional IRA: $447,726

You can see in this scenario, you have another $111,932 in your traditional IRA.

Except we haven’t paid Uncle Sam. Let’s pretend my tax rate in the future is still at 25% for simplicity’s sake.

Nest Egg after 30 Years, 25% Tax Rate:

• Roth IRA: $335,794
• I already paid taxes on the seed!
• Traditional IRA: $335,794
• $447,726-$111,931 (in taxes) because now I’m taxing the tree!

So am I trying to tell you that it doesn’t matter? It’s all a wash in the end? Hardly.

The one key assumption I haven’t talked much about is the tax rate. If you contributed starting at age 35 (start earlier!), until you were age 65, we’re talking about a 30-year spread of future history there. I assumed your tax rate when you started at age 35 would be 25 percent. However, who’s to say that Uncle Sam won’t raise the tax rate to 35 percent? Or, what if you’re earning significantly more money during retirement (now wouldn’t that be sweet?), so you’re naturally in a higher tax bracket, maybe 37 percent?

Nest Egg After 30 Years, 37% Tax Rate:

• Roth IRA: $335,794
• You already paid taxes on the seed!
• Traditional IRA: $282,067
• $447,726-$165,658 in taxes

You’ll have more in your Roth IRA!

What if Uncle Sam lowered the tax rate to 10%…

• Roth IRA: $335,794
• You already paid taxes on the seed!
• Traditional IRA: $402,953
• $447,726-$44,772 in taxes

You’ll have more in your traditional IRA!

You get my point. The tax rate is an unknown variable. When I was 20 years old (thank you to the responsible adults who encouraged me to start investing), I personally chose the Roth IRA for the following reasons:

• I was a college student.
• My tax rate was virtually zero percent.
• I was at the beginning of my “earning potential” and fully expected my tax rate to increase as I started making more money when I got into my career.
• Also, I sure hope I’m in the highest tax bracket when I retire; that means I’ll be making a ton of money.

The difference between the Roth IRA and traditional IRA lies in your current tax rate, and your expected tax rate upon retirement. If you’re young and think your earning potential is going to go up, do some serious tire-kicking to consider starting a Roth IRA. And remember, it’s not set in stone which one you’ll use forever. You can contribute and not contribute at will, and you can even do both simultaneously (subject to certain limits).

Ok, so it took me a few more sentences to explain than the one we started with, but I think we got there.

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This post is for information purposes only and is not intended to be investment advice. Seek a licensed professional for investment advice.

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