Traditional IRA vs Roth IRA

It is very important to understand the difference between a traditional IRA and a Roth IRA. A traditional IRA allows you to put money into investments before paying taxes on it. When you later decide to take the money out during retirement you will be responsible for the taxes fund the original amount invested plus the amount it has grown. This can be a good strategy if you’re making a tremendous amount of money now and expect to make a lot less in the future. It also allows you to make your withdrawals at strategic times when your income is low and will have the greatest tax advantage. However if you are investing early in life your investments may grow significantly more than the amount of principal invested. This means the savings from not having to pay tax upfront may be insignificant compared to the amount you have to pay on the increase from your original investment.

A Roth IRA works the option of a traditional IRA. It requires that you put money in after you pay taxes on it. Since the taxes already paid the government allows you to take the money out during retirement tax-free. If you’re investing early in life and your money will have a long time to grow this is probably the best strategy. When you get ready to take your money out you don’t have to worry about any type of taxes as long as you’re a retirement age. If your money has doubled or tripled in size but thanks to making investments early on this can be a sizable savings.

In particular if you believe tax rates are going up a Roth IRA may be a better strategy. It allows you to pay taxes at the rate you are now and insulate you from taxes on the gains in addition to any higher tax rates in the future.

Of course it is possible that the government will change its mind and tax Roth IRAs in the future. It’s unlikely that they will release an out and out income tax on money removed from an IRA but they may institute some type of value added tax or federal sales tax that will basically capture money when you get ready to spend. However this scenario would also affect any money you try to spin from a traditional IRA so the Roth IRA still provide you with significant protection against increased income tax rates in the future.

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