What’s the difference between a Roth or a Traditional IRA? In a story…
Retirement investing is something that is often confusing for individuals, leading to many questions about whether they are doing the right thing. It can also be confusing to understand what your options are when you’re starting out.
This article is a simple story to help you understand some of the differences between a Roth IRA/401k and a Traditional IRA/401k. While this will not give you all of the details of the accounts, it should give you an idea of the general concepts between the two.
Now to the story…
Once upon a time there were twin brothers, Roth Robbie and Traditional Tom, who set the goal when they turned 20 to celebrate their 30th birthday by each buying a car. They searched high and low and each set their goal on the car of their dreams.
Now, the brothers knew that they would need to work hard and save their money to be able to buy these incredible cars, so they pursued better paying jobs and started saving as much of their income as they could. They also sought out odd jobs: cutting firewood for their neighbors, walking dogs, touching up the paint on homes that needed it, etc.
This continued through the years, with the brothers working together to keep their expenses low and their savings high. Finally, the day before their 30th birthday came, and they were ready to purchase their new cars. They split all the money they had saved in half and got on the bus to go buy their dream cars.
As soon as the brothers arrived at the dealership, the salespeople jumped into action and were eagerly looking to close the deal. The brothers immediately went to the car they had been dreaming of for the past 10 years and started telling the salespeople that this was the car for them. The salespeople quickly separated the brothers so they could focus on each individual and hopefully close them both.
Traditional Tom decided he wanted some options that made the car a little more expensive than he was originally planning to spend, but the salesman working with him assured him that he could afford the car. All he had to do was lease the car instead of buying it outright. Off to the finance office Traditional Tom and his salesman went to purchase his incredible new car and set up his monthly lease payments. This gave Tom the ability to buy his dream car because he would just pay a low monthly lease payment for as long as he owned the car.
Now Roth Robbie was over on the other side of the dealership with his salesman, who kept wanting to add additional options to the car. However, Roth Robbie knew he did not want to pay a penny more than he had saved. The salesman agreed with Roth Robbie that he would be happy with the car they selected, so off to the sales office they went to complete the paperwork. This made Roth Robbie light up with joy that he could pay cash for the car and walk out that day.
Each of the brothers left the dealership extremely happy with their purchases and got home to discuss them. Roth Robbie was excited because he could pay for everything up front and he owned his car for the rest of his life. Traditional Tom couldn’t wait to show Roth Robbie his optioned out car, and low monthly payments that left him more money to go have fun with to celebrate their birthday. Each of them were happy with their purchases and went out to enjoy their 30th birthday party to show their friends what their years of hard work and saving purchased.
How does this story relate to life?
When you are considering which type of IRA/401k you want to use, you choose whether you want to pay for all of your taxes up front like Roth Robbie, or delay paying your taxes until you take money out like Traditional Tom.
Traditional IRA’s allow you to put more money into the account, so ideally the growth you get on that extra money will cover your taxes when you are ready to start taking money out of the account, and ideally you are in a lower tax bracket when you retire, so you will pay lower taxes in the long term.
With a Roth IRA you are paying the taxes before you make your contribution, so you may not be able to save as much. However, when you are ready to start taking money out you will not have to pay taxes on those funds, which can be extremely beneficial if you think you will continue paying a similar tax rate or higher tax rate later in life.
Which one is right for you?
There is no right answer for everyone, it entirely depends on you and what you want to achieve and how you want to handle your financial life. Hopefully this story helped you understand the concepts behind them so you can make the decision that is best for you.
