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Choosing between a traditional IRA and a Roth IRA may seem like a hard decision. Each has its advantages -- but in the current economic climate, the Roth's looking better and better to me.
If all goes as planned, the Roth will let you withdraw your appreciated assets tax-free. With the traditional IRA, you're taxed only when you withdraw the money, presumably in retirement. Until then, your tax hit is deferred, and you get to enjoy a tax break up front, since your contributions reduce your taxable income.
All things considered, both options look equally good at first. But over time the Roth could net you some serious savings.
Weighing the options
Charles Schwab (Nasdaq: SCHW ) has been a solid long-term performer. It's benefitted from, if not partly driven, the rise of discount brokerages, enabling more individual investors to call their own shots. Even as Schwab has steadily lowered its commissions, it has also expanded its scope, offering financial planning services and funds and ETFs of its own.
Over the past 20 years, shares of Schwab have grown at an average annual rate of almost 24%, enough to turn a $10,000 investment into $700,000. A 15% capital gains tax hit on that would amount to $103,500. With a Roth, you'd save that entire $97,000!
Best Buy's (NYSE: BBY ) performance over the years has been even more impressive. The company parked more than 1,000 electronics superstores across the nation, prevailing over competitors such as Circuit City and RadioShack (NYSE: RSH ) . Not content with a narrow scope, Best Buy also offers Geek Squad services and musical instruments, and it's recently tested electric bicycle sales.
In the past two decades, shares of Best Buy have grown at an average annual rate of more than 28% -- enough to turn a $10,000 investment into a whopping $1.43 million. A 15% capital gains tax hit on that would top $210,000. With a Roth IRA, you'd pay nothing.
But even if you'd invested in more average performers, the Roth IRA would have served you well. Even after its swoon during the financial crisis, Citigroup (NYSE: C ) has performed respectably since 1990, with an average annual return of 6.2%. Its powerful push into credit cards and global banking helped make it a leader in the banking industry, and the repeal of the Glass-Steagall Act in 1999 paved the way for its merger with insurance giant Travelers (NYSE: TRV ) . A $10,000 investment in Citigroup 20 years ago would have grown to $33,400, and a tax bill of $3,500 at 15%.
Clearly, the Roth can save you a lot in taxes, even if you aren't prescient enough to pick the stocks that will blow investors' socks off over 20 years. But wait! The picture for the Roth can get even rosier.
If taxes go up ...
Our new health-reform bill comes with a few tax hikes. The capital gains tax rate is heading higher for high-income folks. If that's you, then beginning in 2013, you can expect to pay a 3.8% surtax, bringing your capital gains rate to 18.8% -- which means a Roth can save you even more.
Even without the possibility of higher taxes, the traditional IRA should give you pause. With it, you defer taxes on the income you contribute to your IRA, but you're taxed on it when you withdraw it in retirement -- presumably at a lower tax rate than you're paying now. But not all of us will have significantly lower tax rates in retirement. If you've saved and invested well, you may have an income similar to the one you have now. As you make your portfolio more conservative, you may also have significant bond interest income, which will get taxed at your regular income rate.
And here's the kicker: Income tax rates may well go up by the time you retire. After all, recent wars, entitlement expansions, and stimulus spending have left us facing a massive budget deficit. It's very possible that the taxes you're deferring now with a traditional IRA will be lower than the ones you'll end up paying later.
Neither the Roth nor the traditional IRA is right for everyone in every situation. Take the time to learn more about how to make the most of your IRA -- and your 401(k). Making smart decisions now can help you avoid ending up with a gruesome retirement.
Do you think tax rates are heading up or down in the future? Is that a good or bad thing? Let us know -- leave a comment below!
The Roth IRA can be a great home for companies that could help you make millions from thousands.