If you're like most Americans, you have the choice between two types of Individual Retirement Accounts, or IRAs. Traditional IRAs have been around the longest (as the name implies) and Roth IRAs are available to most people, but each have their own restrictions and benefits.
The contribution limits are the same for both accounts (currently $5,500 per year), as is the age at which the account holder can begin to take distributions (59.5 years old).
However, there are several important differences between traditional and Roth IRAs. Let's take a look at the key differences between the two, and then at a comparison of how a hypothetical investment would do in both accounts.
In a nutshell, traditional IRA's allow people to put aside money for retirement, and pay no tax on the money you contribute, provided certain criteria are met. Anyone can contribute to a traditional IRA and defer the taxation of investment earnings, regardless of income level. However, in order to qualify for the tax deduction on one's contributions, the contributor's income must be below a certain level.
For the 2013 tax year, single filers' eligibility for a deduction begins to phase out above $59,000 if they are eligible to participate in a retirement plan at work, and married couples must make below $95,000 to qualify for the deduction . There is a chart of qualifying income amounts here, which includes partial benefits for some higher-income individuals, as well as the loss of eligibility by being covered by an employer-sponsored retirement plan.
The major difference between a Roth IRA and a Traditional IRA is whether the taxes are deferred now or later. A Roth IRA allows for contributors to pay tax on their income now, then withdraw the money and investment gains tax-free later on.
The maximum contribution to either type of IRA is $5,500 for both the 2013 and 2014 tax years ($6,500 if the contributor is over 50), but unlike traditional IRAs, if your income is above a certain level, you cannot contribute to a Roth IRA. Married couples must earn below $178,000 in order to qualify for a full contribution, but may qualify for partial eligibility with incomes up to $188,000.
Another nice perk of a Roth IRA is that you can withdraw your contributions with out penalty or taxes at any time. The logic here is that you've already paid income taxes on your contributions so you are free to do whatever you want with the money. Any gains on your investments must be left in the account, however.
The difference it makes with a high-dividend stock
For the sake of comparison, let's see what difference the two types of IRAs can make in both the immediate term and over the long-term. Let's assume that our contributor qualifies for both types of accounts and can write off the full contribution into a traditional IRA.
Let's say our investor puts the maximum contribution ($5,500) into a variety of stocks with an average dividend yield of 4% and an average share price appreciation of 6% annually, a pretty conservative estimate. We'll assume a 30-year timeframe and that all dividends are reinvested.
To open the account, a traditional IRA investor can simply put $5,500 into an account, and is not taxed on that portion of their income. A Roth investor has to pay tax on their income, making their effective initial investment $6,875 when accounting for the initial taxation of the income if they are in the 25% tax bracket
After 30 years, with our above assumptions, both accounts would have grown the initial $5,500 investment to $95,971. Not a bad return on the original investment, right? And this is only one year's contribution.
The difference lies in how the investment is taxed when it is withdrawn. The traditional IRA investor has to pay taxes on any distributions, so the withdrawable amount is around $72,000 assuming a 25% tax rate (which may be higher or lower in your individual situation). The Roth IRA holder is free to withdraw the entire amount tax-free, because he/she already paid taxes on their original income.
So, the traditional IRA took an investment of $5,500 and turned it into $72,000 in 30 years, an effective annual return of about 9.3%. The Roth IRA effectively cost $6,875 for the initial investment and grew to a useable $95,971, for a slightly higher 9.5% rate of return.
So, is one better than the other? It depends...
Both accounts had similar returns over the long term, but these results can vary significantly depending on your tax rates both now and at the time you begin withdrawing the money (almost impossible to predict). Roth IRAs are designed to benefit lower-income individuals, as they get taxed less on their current income and will have no tax liability on the future earnings of their investments.
Do a little research and see exactly what your personal situation and income allow you to do, and invest all you can in one of these. You'll be glad you did later!