My column today focused on a poll by Baltimore’sT. Rowe Price that found younger investors less inclined to invest in an individual retirement account this year. If anyone can benefit from a tax-sheltered IRA, it’s younger investors who have the time to see their earnings compound over time..
But if younger investors need another reason to invest in a Roth IRA, here it is: $133,063. That's how much in taxes you can avoid on your nest egg by going with the Roth.
There are two types of IRAs: A traditional IRA that allows investors within certain income limits to deduct their contributions on their tax return. And the Roth, in which you get no upfront tax deduction but the principal and earnings can be withdrawn in retirement tax free.
Mathematically, the accounts are supposed to come out the same. The idea is that investors contributing to a Roth put less money into the account because they pay taxes upfront on the money. The theory is that if one investor puts $1,000 in a traditional account, another would put, say, $750 in a Roth after taxes.
But T. Rowe Price’s Stuart Ritter points out that that’s not how people invest. If they decide to invest $1,000, they will put that amount in the account and not put in less because of upfront taxes.
So, given that, Price’s Neil Cooper has run the math on two investors contributing to a traditional IRA and a Roth. Cooper assumes each puts in $5,000 a year — the maximum annual amount for those under 50 — between 35 and 49. And then, each increases contributions by $1,000 a year as a catch up contribution between 50 and 64. The calculation assumes a 7 percent annual return.
At age 65, each investor has accumulated $532,253.
The Roth investor doesn’t have to pay taxes on any of that. But the nest-egg in the traditional account is subject to taxes: $133,063 worth.
Even if the investor with the traditional IRA took the tax deduction received all those years and invested it in a taxable account, he or she would still come out less than the Roth IRA investor, according to Price.
Bottom line: young investors should put money in a Roth IRA if they can afford to do so.