Having a healthy nest egg for retirement can be boiled down to three factors: how much money you set aside for retirement, how much growth your investment generates, and how long you have the money invested.
While earning significant growth on your assets is needed, it is not easy to control because you can’t control the stock market. Having a long time to invest is easy when you are younger, but progressively that factor gets worse as the timeline gets smaller; plus you can’t really control the passage of time.
The easiest factor to control by far is how much money you invest for retirement. You can decide today to save more money for retirement in an account such as a Traditional or Roth IRA. But today I’m going to show you that while a Traditional IRA is nice, a Roth IRA allows you set aside more money for retirement even though the contribution limits are the same. How is that possible? It all comes down to Roth IRA rules. Read on.
Traditional and Roth IRA Contribution Limits
In 2011, the contribution limit for both types of IRAs is $5,000 if you are not using catch up contributions. In future years, contribution limits will be tied to inflation increases. For now, you are limited to a flat $5,000 this year.
The Impact of Taxes on Your Contribution Limit
The difference between a Traditional IRA and Roth IRA is how your contributions are taxed. With a Traditional IRA you get a tax break by contributing the $5,000 this year. You do not pay taxes on that $5,000 until you pull it out of the IRA in retirement.
When you look at the Roth IRA side of things, you are contributing $5,000 in after tax dollars. You pay taxes today and you never pay income tax on your contributions.
Many people believe that getting a tax deduction today with a Traditional IRA contribution allows you to set aside more money for retirement because you aren’t paying taxes on the contribution today.
This is actually the opposite of the truth. A Roth IRA lets you save more of your income for retirement. Here’s the math. We’ll assume you are in the 25% tax bracket so any pre-tax contributions will save you 25%, and any post-tax contributions will be made with dollars that have been reduced by the tax.
- To contribute $5,000 to a Traditional IRA, the contribution comes from pre-tax income. To contribute $5,000 you need to simply earn $5,000.
- To contribute $5,000 to a Roth IRA, you have already paid 25% tax on the amount of the contribution. That means you needed $6,666.67 of pre-tax income to get to $5,000 in post-tax contribution. You have set aside more of your income for retirement with a Roth IRA.
A different way of looking at the math:
- A $5,000 pre-tax contribution into a Traditional IRA that never grows will be worth $3,750 after the 25% income tax is applied when you withdraw the money from the IRA.
- A $5,000 Roth IRA contribution that never grows will be worth $5,000 when you withdraw the money from the Roth IRA because you have already paid tax on it.
The bottom line is you can save more of your income for retirement by using a Roth IRA.
Start saving for retirement now – there is no time like the present. Check to see if your income falls below the Roth IRA income limits. If you are eligible, there isn’t a better type of retirement account to open. Take control of your future and open a Roth IRA today.
This article is by RothIRA.com’s Senior Editor, Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008. You can follow him @RothIRAdotcom.