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A Roth IRA is a great way to save for retirement.

Simply put, a Roth IRA is just an investment vehicle for retirement. IRA is the acronymn that is used in place of Individual Retirement Arrangement.

The primary difference between the Roth IRA and other retirement accounts such as the 401K, 403B, pensions, and a regular IRA, are that Roth IRA's have a different tax advantage:

While the contributions toward a 401K and 403B plan have the tax-advantage on the front end. By this i mean that contributions are taken before taxes are collected by the Government. So if you were to contribute $5,000 for the year and are in the 25% tax bracket, you are essentially saving $1,250 on taxes for the year or paying only $3,750 net for $5,000 worth of stock and and mutual funds ($5,000 - $1,250 =.$3,750) In addition, this money grows tax-free every year until retirement. This is a very nice feature of both the 401K and the 403B, however retirees are later taxed by the government when the money is withdrawn. If you consider the 401K and 403B at the long-term horizon, you are not really "saving" money on your taxes but rather just "deferring" it to a later date, which is why I like to say that these retirement accounts have the tax-advantage on the front end.

Roth IRA's, on the other hand, has the tax-advantage on the back end. These contributions are taken with money that has already been taxed. However, once you are eligible for retirement and begin to take withdrawals from your Roth IRA account you will not be taxed again. Assuming you were to contribute $5,000 for the year, you would be paying with money that had already been taxed. So, your net contributions would be $5,000. If you were to look at this amount in terms of the front end tax-advantaged accounts, it would be equivalent to you paying $6667 if you fall into the 25% tax bracket ($6667 multiplied by 75% equals roughly $5,000). Like the 401K and 403B retirement accounts, the Roth IRA also grows tax free, but as I mentioned earlier the tax-advantage for the Roth IRA is on the back end. You will not be taxed on this money again when it is withdrawn at retirement.

How do the tax-advantages factor in to your retirement income:

Some of the sceptics out there might be wondering why would you ever pass up on the 401K or 403B plans. The answer is that you should not necessarily pass up on either the 401K or 403B, you should however only contribute up until your employer match level, and then make any additional contributions you can afford to a Roth IRA... Now, in the first example I gave you can see that you were able to fund your 401K or 403B for the year with net $5000 and really only be paying $3,750 after tax is taken out, while the Roth IRA account is funded with net $5,000 (which you could essentially look at as costing you $6,667 of pre-tax income). Looking at the first year scenario I just laid out may make you further wonder why anyone would contribute to a Roth IRA, and in order to see why we need to turn our focus to our end goals and look at the scenario at the time of retirement (remember me saying that the Roth IRA is tax-advantaged on the back end... the following example will show you exactly how it works.

For this example we will assume that Pete Savers will be contributing to both his 401K and a Roth. Pete is 25 years old and will be saving $5,000 per year in each of his two retirement accounts. Pete will earn 10% annually on his investments. Pete is in the 25% tax bracket. Pete will retire at the age of 65. I input the the data into excel as you can see directly to the right.

Below I have computed the true value of the 401K and Roth IRA's based on the assumption that his tax bracket rises to 35% at the age of retirement (considering Pete will have millions in retirement income it is likely to increase once he starts making withdrawals). However, I believe that the average person will likely see their tax rate increase even higher than that over time as most people will earn a higher income the further they are into their working years. I also believe that individual tax rates could increase to extremely high rates organically as our country falls deeper into debt regardless of your income level.

If Pete were to retire at the age of 65, his Roth IRA will be worth over a half a million dollars more than his traditional 401K.

Please feel free to verify the results below or click here to check for yourself at dinkytown.net. It is a very cool program and you can feel free to play around with the inputs for the contributions, tax rates, anticipated interest rate, and various other factors...

How were these results calculated?

A Roth 401(k) may be worth $520,397 more than a traditional 401(k). How was this calculated?

Step 1: First we found the value of a Roth 401(k) if you contributed $5,000 per year for 40 years earning an assumed 10% per year. This equaled $2,331,087. Since qualified withdrawals from a Roth 401(k) are not taxed, the total value remains $2,331,087.

Step 2: We then computed the totals for a Traditional 401(k). Again we determined the value of $5,000 per year for 40 years earning an assumed 10% per year. This is the same amount as the Roth 401(k) total, $2,331,087. However, contributions and all earnings in a Traditional 401(k) are taxable when they are withdrawn. After taxes, the value of your Traditional 401(k) account would be $1,515,207.

Step 3: Since you receive a current year tax deduction for any Traditional 401(k) contributions, we need to determine the value of investing this tax savings and add this amount to the Traditional 401(k) total. If we forget this step, our comparison will not be equal. We would, in effect, be contributing more to our Roth 401(k) than the Traditional 401(k). If your tax savings were invested for 40 years at an assumed rate of 10%, this returns a total of $295,483 after taxes.

Results Summary

Traditional 401(k) Contributions $200,000

Roth IRA Contributions $200,000

Total before taxes

401K $2,331,087

Roth IRA $2,331,087

Value of investing tax savings

401K + $295,483

Roth IRA + 0

Taxes for 401(k) at retirement

401K - $815,880

Roth IRA - 0

Value at retirement (age 65)

401K $1,810,690

Roth IRA $2,331,087