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 When you retire, the full amount withdrawn is taxable as ordinary income.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.

RELATED FAQS
  1. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
  2. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  3. Can my IRA be used for college tuition?

    You can use your IRA to pay for college tuition even before you reach retirement age. In fact, your retirement savings can ... Read Full Answer >>
  4. Why are IRA, Roth IRAs and 401(k) contributions limited?

    Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy ... Read Full Answer >>
  5. How do you calculate penalties on an IRA or Roth IRA early withdrawal?

    With a few exceptions, early withdrawals from traditional or Roth IRAs generally incur a tax penalty equal to 10% of the ... Read Full Answer >>
  6. What are the best ways to use your 401(k) without a penalty?

    The best way to use your 401(k) retirement savings account is to take normal distributions after you reach retirement age. ... Read Full Answer >>
Related Articles
  1. Professionals

    Your 401(k): How to Handle Market Volatility

    An in-depth look at how manage to 401(k) assets during times of market volatility.
  2. Professionals

    How to Build a Financial Plan for Gen X, Y Clients

    Retirement is creeping closer for clients in their 30s and 40s. It's a great segment for financial advisors to tap to build long-term client relationships.
  3. Professionals

    Don't Let Your Portfolio Be Trump'd by Illiquidity

    A look at Donald Trump's statement of finances and the biggest lesson every investor can learn.
  4. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  5. Retirement

    Maxing Out Your 401(k) Is Profitable: Here's Why

    It's shocking, but most American workers (73%) have no 401(k) retirement funds. Start saving now to anchor your retirement.
  6. Professionals

    Top Questions to Ask When Choosing a Robo-Advisor

    Think a robo-advisor might be the right choice for you? Be sure to ask these questions first.
  7. Professionals

    Top Retirement Hack? Start with a Lifestyle Change

    Instead of going through the usual retirement planning steps, some people are focusing on fostering a lower cost lifestyle from the start.
  8. Insurance

    Picking the Best Longevity Insurance

    What you need to know before buying a "reverse life" policy.
  9. Retirement

    Best Ways to Save For Retirement Without an IRA or 401(k)

    Learn the most common types of savings vehicles used to accumulate money for retirement outside employer-sponsored 401(k)s or IRA accounts.
  10. Retirement

    Inherited IRA and 401(k) Rules: Don't Run Afoul

    What you need to know when it comes to the complex rules for inherited IRAs and 401(k)s.
RELATED TERMS
  1. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
  2. See-Through Trust

    A trust that is treated as the beneficiary of an individual retirement ...
  3. Backdoor Roth IRA

    A method that taxpayers can use to place retirement savings in ...
  4. Current Service Benefit

    The amount of pension benefit accrued by an employee who had ...
  5. Self Invested Personal Pension (SIPP)

    A tax-efficient retirement savings account available in Great ...
  6. Elder Care

    Elder care, sometimes called elderly care, refers to services ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!