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    Traditional IRA vs Roth IRA

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    Suppose one of your clients is four years away from retirement and has only $2,500 in pretax income to devote to either Roth or traditional IRA. The traditional IRA permits investors to contribute the full $2,500 since contributions to these accounts are tax-deductible, but they must pay taxes on all future distributions. In contrast, contributions to a Roth IRA are no tax-deductible. For example, if a person's tax rate is 25 percent, an investor is able to contribute only $1875 after taxes; however, the earnings of a Roth IRA grow tax free. Your company has decided to waive the one time set up fee of $50 to open a Roth IRA; however, investors opening traditional IRA must pay the $50 set up fee. Assuming that your client anticipates that her tax rate will remain at 19 percent in retirement and will earn stable 7 percent return on her investment, will she prefer a traditional or Roth IRA?

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    Solution Preview

    Traditional IRA
    Tax savings for $2500 contribution today: 2500 x 25% = $625
    Fee for setup of IRA = $50
    Tax cost when withdrawn: $2500 x 19% = $475
    Tax on earnings at 7% compounded annually for 5 full years is $1006 x 19% = $191
    Total tax is $475 + $191 = $666

    Roth IRA
    Tax cost for $2500 to a Roth rather than a traditional IRA: 2500 x 25% = $625
    Fee for setup of Roth = $0
    Tax savings when withdrawn: $0
    Tax on earnings = $0

    Variable factors that could influence the decision:
    1. Traditional IRAs are subject to the RMD (required minimum ...

    Solution Summary

    The traditional IRA versus Roth IRA are examined. The investors for opening traditional IRA are provided. The clients anticipated are given.

    $2.19

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