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What’s so Great about a Roth IRA?

The Roth IRA is finally some good news for the U.S. taxpayer. The Roth IRA


allows an investor to build a retirement account without paying taxes on that growth, or even reporting dividends, earnings, or capital gains as the account grows.

The reason a Roth IRA allows tax-free growth is because it requires an investor to pay taxes first. The after-tax savings is then accumulated tax free.

Why is this such a great deal if I have to pay taxes first?

Because you could pay taxes later on the entire balance, or you could pay taxes now and never again pay taxes on your accumulated gains and earnings. If you initially contribute $5,000 to a Roth IRA, then buy stock and other investments and somehow turn it into $50,000,000 over the course of your life, you would never pay tax on the capital gains and earnings of $49,995,000 because you already paid tax on the $5,000 initial contribution! Just be sure and let me know what stocks you are buying!

Of course the example is exaggerated to point out the advantages of the Roth IRA.

If you do have investments that you think will go up significantly, it is much better to have them in a Roth IRA than a pre-tax account where you will have to pay tax on all gains and earnings. And for long-term compounding, you can also pay you tax first, let the power of compounding grow your investments for many years, and never pay tax on that growth. You can even pass the Roth IRA on to your heirs tax-free. Now that is smart tax planning. There is nothing worse than getting a gift loaded with a big tax bill, except maybe no gift at all.

IRA vs Roth IRA

The Roth IRA is the exact opposite of a traditional IRA. Under a traditional IRA, taxes are deferred until you withdraw the funds. Keep in mind that this means the entire balance eventually becomes taxable. There is a very big difference between tax-deferred savings and tax-exempt savings. The growth within a traditional IRA is tax deferred, and the growth within a Roth IRA account is tax-exempt. I will take the latter, and so should you!

Roth IRA’s sound great, so what’s the cost?

The cost is simply that you pay taxes now, not later. Under a traditional IRA, you defer taxes until later.

The main assumption for opting into a traditional IRA is that you will be under a lower tax bracket during your retirement  years, or otherwise pay less in taxes. This assumption is faulty for several reasons. The primary reason is that the U.S. government is deeply in debt, and there is no guarantee that future tax rates will be lower. They very well could be higher due to a series of costly wars, Medicare, Social Security, an aging population, and bank bailouts. Already we are seeing a 3.8% added surtax on unearned income beginning in 2013 from the Health Care Reform Act.

But the second reason is that with the combination of retirement savings, social security, and other income, the typical tax rate is not as low as most people think. Retirees may also return to work, take part-time jobs, own a small business, or produce other income that puts them in a higher tax bracket. The bottom line is that we are trained to think that paying taxes later is better; just put them off as long as possible. But it is a much better trade off to pay taxes on your contributions now than to on your entire retirement balance taxed at a later date.

This is a key point that you should let resonate deep within your financial memory banks. Go ahead and take a sip of coffee and think about that for a moment. If you plan on passing your retirement balance to your kids or other heirs, think about it again!

For these reasons, the Roth IRA is the clear winner over the traditional IRA hands down!

Make sure you keep your tax-exempt status, click Roth IRA Rules for the details.

Traditional IRA Rules

IRA vs Roth IRA

Roth IRA Contribution

Roth IRA Conversion

Roth IRA Rules

Roth 401k

Roth IRA Recharacterization

Inherited Roth IRA

Non-Deductible IRA

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