What's the best kind of IRA for a 20-something?

By Steven Merkel AAA
A:

There probably is no 100% correct answer here, but let's break it down.

Suppose that you are 23, you've been working for a couple of years and are now earning $50,000 per year. For 2008, you can contribute up to $5,000 to an IRA (Traditional, Roth or a combination of both). If you ask your CPA, he or she will most likely tell you to contribute to the Traditional IRA to receive the tax deduction, which will save you approximately $1,250 in federal tax due each tax year, assuming that you are in the 25% tax bracket and you qualify for the full deduction. Let's break down the deduction limits for Roth and Traditional IRAs.

Rules for 2008
If you are also covered by an employer-sponsored retirement plan and are:
-Making less than the $53,000 modified adjust gross income (MAGI) limit, you get the full deduction
-Making between $53,000 and $63,000 MAGI, you get a partial deduction
-Making more than $63,000 MAGI, your Traditional IRA contribution is not deductible

If you are not covered by an employer sponsored retirement plan, the full contribution will be deductible regardless of other factors.

If you make Traditional IRA contributions, you get the tax deduction now and tax-deferred growth on the earnings. When you retire, the full amount withdrawn is taxable as ordinary income.

For example, suppose that you contribute $5,000 per year to a Traditional IRA until you are 63 years old (40 years of saving $5,000 = $200,000) and your Traditional IRA grows to $2,212,962 by the time you hit age 63 (this is possible at a 10% return). Assuming that all your contributions were fully deductible, you saved $50,000 in taxes over the 40 years.
However, now that you are retired, you decide to withdraw $100,000 per year from your Traditional IRA. If you are still in a 25% tax bracket, you will pay $25,000 in income tax on each $100,000 withdrawal each year thereafter. As a result, you net out $75,000 in income per year. (To learn more, read Traditional IRA Deductibility Limits.)

The Roth works differently. Suppose you contribute the same $5,000 per year for 40 years to a Roth IRA. You get no immediate tax deduction, but the Roth IRA still grows to $2,212,962 (assuming a 10% annual return). At age 63, you withdraw $100,000 per year. The difference now is that there is no tax due on the Roth withdrawal, because Roth distributions made after retirement are tax free. In this scenario, you withdraw $100,000 and keep the full $100,000. In this case, the Roth IRA is clearly the best and wisest long-term investment decision for someone this age. (For more insight, see Tax Treatment Of Roth IRA Distributions.)

This questions was answered by Steven Merkel.

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