Doing the Math on a Roth IRA

illu_redNow 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 there are 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 the Chevy Ira to keep it running smoothly ($5,000 is your limit for 2010 and you stick with it, year after year). A friend also wants to invest in cars, and she buys the Ford Rothie and puts the same $5,000 into it each year.

That’s fine, because you both 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 will have to pay taxes on all the money you made. That’s because, under a special clause in the sales contract, you were allowed to put in pre-tax dollars—i.e. all those  $5,000 chunks were deducted from your income, so you didn’t pay tax on them.

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, your pal’s Ford Rothie is different. She used after-tax money to pay those $5,000 chunks each year. So the tax is already paid. The Rothie is worth $340,000–and when she cashes it in, she keeps that full amount.

Some people prefer IRAs, because they want the tax deduction. Others prefer Roth IRAs, because they’d rather pay tax now than later. You can own both, but your contribution is limited to $5,000 per year, in each account (e.g. $3,000 in your IRA and $2,000 in your Roth).

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!