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Everyone loves a chance to avoid paying huge amounts of taxes, and for many people, opening a Roth IRA could give you exactly that opportunity. But depending on your particular financial situation, a Roth IRA may not give you a huge benefit over other types of retirement accounts.

Roth IRA madness!
I'll admit that when it comes to picking an IRA, I'm one of the biggest proponents of the Roth IRA that you'll ever find. In exchange for forgoing a current tax deduction on the money you contribute, you get to enjoy tax-free growth for as long as you choose to leave that money inside your Roth IRA. In addition, you won't have to pay taxes when you withdraw that money. That's an amazing opportunity, especially if you're planning to invest for a really long time.

Moreover, when it comes to taxes, there's some value in certainty. You can't be sure what tax rate you'll pay 20 or 30 years from now, but you do know what your tax rate is now. The Roth lets you get those taxes out of the way when they're a known quantity.

Do your own taste test
But anything that requires you to predict what the future will bring makes it really hard to be certain whether a Roth IRA will always work out to be your best option. It's easy to come up with a scenario where it really doesn't make much difference whether you go with a Roth or a traditional IRA.

For instance, say you're a typical investor in the 25% tax bracket and are trying to decide what kind of IRA to use this year. You've got $3,000 to invest right now, but you'd also be willing to invest whatever tax savings (if any) that you earned from your IRA contribution.

If you go with a Roth IRA, you won't get an extra tax break right now, so you'll have $3,000 to contribute. On the other hand, if you pick a traditional IRA, assuming you get your tax refund back before the tax deadline, you can actually contribute $4,000, because you'll get a $1,000 tax break back by deducting your full contribution.

Over the years, that amount can grow immensely. Here are some examples of what some commonly held stocks have done over the past 30 years, just to give you a sense of the magnitude of gains:

Stock

$3,000 in Roth IRA Grows to...

$4,000 in Traditional IRA Grows to...

ExxonMobil (NYSE: XOM  )

$238,435

$317,913

Procter & Gamble (NYSE: PG  )

$168,941

$225,255

Johnson & Johnson (NYSE: JNJ  )

$248,466

$331,288

Alcoa (NYSE: AA  )

$32,153

$42,870

Ford (NYSE: F  )

$45,429

$60,571

Boeing (NYSE: BA  )

$78,221

$104,294

General Electric (NYSE: GE  )

$123,692

$164,923

Source: Yahoo! Finance.

As you can see, even a single IRA contribution can turn into real money given enough time.

Now, at first glance, you might think the traditional IRA is the obvious choice, since it has a lot more money in it. But remember: that money will get taxed when you withdraw it. In fact, if you assume you're still in the same 25% bracket when you take your money out, an interesting thing happens:

Stock

Pre-Tax Value of Traditional IRA

Amount Left After Tax at 25% Rate

ExxonMobil

$317,913

$238,435

Procter & Gamble

$225,255

$168,941

Johnson & Johnson

$331,288

$248,466

Alcoa

$42,870

$32,153

Ford

$60,571

$45,429

Boeing

$104,294

$78,221

GE

$164,923

$123,692

Look familiar? It turns out that after taxes, you have exactly the same amount of money you would have had if you'd gone with a Roth IRA. Put another way, you wouldn't have gotten any benefit at all doing a Roth instead of sticking with a basic traditional IRA.

In fact, if you change the assumptions a little bit, you might do even better with a traditional IRA. If your tax rate goes down in retirement -- something that's certainly conceivable if you go from a high-paying job to living off your investments -- then you'd pay less in taxes, keeping more of your money for your retirement.

Cover your bases
Given the future uncertainty about tax rates, you might want to hedge your bets by splitting your money among Roth and traditional retirement accounts. If you have a regular 401(k) account, for instance, a Roth IRA could help give you tax diversification. If your rates go up, then your Roth will protect you somewhat. If they go down, then your traditional retirement account will be the better move.

Whichever you pick, though, don't pass up using some type of tax-favored account for retirement. The benefits are too good to ignore.

To get the full scoop on traditional and Roth IRAs, as well as great tips on how to open and fund an account, check out the helpful materials in the Fool's IRA collection.

Fool contributor Dan Caplinger hopes he never has to give up his Roth IRA. He owns shares of GE. Johnson & Johnson and Procter & Gamble are Motley Fool Income Investor picks. The Fool owns shares of Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never makes you make a tough decision.


Read/Post Comments (4) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 19, 2009, at 3:42 PM, KevinNU7 wrote:

    Glad to see you basically rewrote the article from a week or two ago about this topic and corrected yourself.

  • Report this Comment On October 19, 2009, at 9:01 PM, vgbrocklebank wrote:

    What am I missing here, a change in the tax laws in the future making roth IRA taxable ?

  • Report this Comment On October 19, 2009, at 11:26 PM, airforceja wrote:

    No thanks on the Roth, I'll take my tax break now, thank you. Who knows what the future holds, or whether I'll even be around to enjoy it. What I can be certain of is that I get a tax break now with a traditional IRA.

  • Report this Comment On October 20, 2009, at 1:00 PM, davro wrote:

    I would like to se this article rewritten with a comparrison to not using an IRA at all. The value of the investment would only be subject to a "possible" capital gains tax of 15%.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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