Doing the Math on a Roth IRA

By MP Dunleavey on Thursday January 07, 2010


Now that we're all focused on Saving UP!, I want to address one of the great IRA puzzles: What is the difference between a regular IRA and a Roth?

Luckily, it's an easy and fun question to answer.

Let's imagine you have two cars: a Chevy Ira and a Ford Rothie. They are very special cars, designed to gain value over time.

You decide to put $5,000 a year into each one to keep it running smoothly ($5,000 is your limit for 2010 and you stick with it).

That's fine, because you know that in 30 years these cars will be considered valuable antiques. But…because of the contracts you signed for each car, there's a catch!

In 30 years, you can sell your vintage Chevy Ira, but you have to pay taxes on all the money you make. That's because, under a special clause, you were allowed to put in pre-tax dollars—i.e. all those years, you never paid tax on those $5,000 chunks.

Assuming that this whiz-bang car has gained immense value on the antique car market--say, 7% per year--your Chevy Ira is now worth about $340,000.

But because you owe taxes on it, you pocket only about $240,000.

Now, the Ford Rothie is different. You used after-tax money to pay those $5,000 chunks each year. So the tax is already paid. You pocket $340,000.

Obviously, there are some finer financial points to understand, but this covers a key one. For example: You can contribute to both a an IRA and a Roth, but your contribution limit is $5,000 combined for 2009 and 2010. For the purposes of our fable, we allowed $5K in each "car" so you could see how each performed.

Next up: What's a Roth conversion? Is it spiritual? If you are thinking of converting to a Roth, contact us and we'll walk you through it!