The traditional IRA, in contrast with the Roth, has its tax advantages at the beginning rather than the end. A traditional IRA gives you a tax deduction at the beginning when you put money into it, whereas a Roth gives no "up front" tax deduction. Like a Roth, the traditional IRA grows tax free. But, unlike a Roth, the proceeds of a traditional IRA, when withdrawn, are fully taxable.
Let's consider Jane and ask whether it would be a good decision for Jane to put her money in a traditional IRA instead of a Roth. You can see - from the Roth discussion - that if she puts $2,000 in a Roth she would have $128,000 42 years later. Can she do as well with a traditional IRA? Let's suppose that between federal and state taxes, she is in the 40 percent bracket now and will be in the 40 percent bracket in her retirement years. She puts $2,000 in a traditional IRA and thereby gets a tax deduction and saves $800 (or 40 percent of $2,000) in that first year. Let's suppose her traditional IRA also doubles every seven years. Once again, the IRA will amount to $128,000 in 42 years at which time she withdraws it from the IRA. On withdrawal from the IRA she pays a tax of $51,200 (or 40 percent of $128,000) and has $6,800 left from the IRA. This $51,200 appears, at first glance, to be much less than the tax free $128,000 she could withdraw from the Roth. But we haven't considered yet what she did with the $800 of tax savings in the first year. If we could ignore taxes and if she were able to invest it so that it too would double every seven years, she would exactly make up the $51,200 difference between the two IRA approaches. But of course the point of this whole exercise is to consider taxes and it seems unlikely that we can avoid taxes. She will probably have to pay considerable taxes on the $800 as it accumulates. With the $800 accumulating subject to tax it will be very difficult for Jane to do as well with the traditional IRA as with the Roth.
Suppose Jane has some very optimistic views about tax rates in the 21st Century. She believes that the combined federal and state tax rates when she retires 42 years from now will be close to zero and, to make a very simple point, let's suppose they will be exactly zero. In that case the traditional IRA would be a better choice. She will have the same $128,000 in either the Roth or the traditional and will be able use either tax free. But in addition, she will have whatever the $800 tax saving from the first year may have accumulated to over the 42 years. At any positive rate of return she will have more with the traditional IRA than with the Roth.
Yes, this discussion is incomplete and you're invited to return here soon for a more complete discussion.
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