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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 Summary

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

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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Tax cost when withdrawn: $2500 x 19% = $475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Tax savings when withdrawn: $0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 ...

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