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Investing Your Tax Rebate: Traditional vs. Roth vs. 401(k)

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  1. The Choice between Traditional IRA and a Roth IRA
  2. The Roth IRA
  3. The Choice between a 401(k) and a Roth IRA
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You might decide to put your tax rebate away for a comfortable future. Retirement savings expert Gail MarksJarvis helps you choose between traditional and Roth IRAs, and looks at the best ways to fund your 401(k).
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The Choice between Traditional IRA and a Roth IRA

Too many people suffer from IRA paralysis, because they can't figure out whether to choose a traditional tax-deductible IRA or a Roth IRA. I don't want you to succumb, because behavioral studies suggest you will then let months or years go by without ever deploying your first $1 into one of these money-making machines. Simply because you are mulling the choice of IRAs, you may cost yourself thousands of dollars in potential retirement money as you leave savings gathering dust in a savings account.

Consequently, if you see that you would qualify for either, and you find yourself in the throes of procrastination, take out a quarter. Call one side "Roth IRA" and the other side "traditional IRA." Then flip that quarter in the air, and whichever side turns up, go for it.

I say this because both IRAs are tremendous choices—huge tax savers, and consequently a no-brainer for growing your money. On the other hand, understanding the variations is not difficult. In a nutshell, the choice comes down to this: In addition to years of tax breaks, do you want an extra serving of tax help at the time you contribute money to an IRA, or do you want to delay it until you are retired?

The Traditional Tax-Deductible IRA

Let's start with a traditional tax-deductible IRA, because there was a time when there was only one IRA—the traditional IRA. When the first IRA was introduced several years ago, people were sold on them as a way to cut their taxes each year. And that's still the appeal today. You can open a traditional IRA, deposit money up to the government's limit for that year, and use that contribution to reduce the amount of taxes you owe Uncle Sam at tax time for that particular year.

Say you earn $20,000 a year on your job, and you decide to put $3,000 into a traditional IRA this year. Because you did this, you are going to reduce your income when you fill out your tax return for this year. In effect, you tell the government at tax time that you didn't really make $20,000. Instead, your income was only $17,000, because you removed $3,000 to start the IRA. Since your income is no longer $20,000, the government is going to tax you on only $17,000. So instead of having to pay $1,355 in taxes, you will pay only $905. By opening an IRA, you cut your tax bill down by $450. If you want to try this calculation, go to www.dinkytown.com and use the tax estimator.

To look at it another way, because you saved $450 in taxes that year, it only cost you $2,550 to open your IRA—not $3,000.

Getting the tax break in a single year is a good deal. Of course, if you contribute again the next year, you can cut your income and taxes again. You can do this year after year—every time you make a contribution you reduce your taxes at year-end.

But the benefit is so much more than that. Year after year, Uncle Sam also keeps his hands off everything that's invested in the tax-deductible IRA. If your $3,000 earns $100, you will have $3,100 in your IRA, and you won't get taxed on any of it. If, years later, it's grown to $50,000, you still won't need to pay taxes on it. Consequently, your savings—free of taxes—will grow with gusto thanks to the power of compounding on a pot of money that never gets whittled away by taxes.

That original $3,000 should turn into about $49,000 tucked away in your IRA for 35 years, but if you hadn't held the tax man at bay, you would have accumulated only about $24,000. (I'm assuming you are in the 25 percent tax bracket and earn 8 percent annually on your investments.)

Now, here's where that traditional IRA takes a turn you might not like. The gig comes to an end when you retire. That's when Uncle Sam's bill starts coming due. Remember, you have been saving throughout your working years in an IRA so that you could start giving yourself a paycheck each year of retirement. As you go into that period of your life, Uncle Sam starts showing up every time you pay yourself. There's nothing you can do about it. He will tax any money you remove from the IRA. Of course, if you don't need the cash early in retirement and you just leave it in the IRA, you still won't owe any taxes on your savings.

But Uncle Sam wants to make sure he gets a piece of the action, so he won't let you duck him forever. Once you turn 70 1/2, he will require you to remove a portion of your IRA money—whether you need it or not—every year. Then Uncle Sam will take his share of that money, taxing it just as he would a paycheck. Still, the money remaining in your IRA—no matter how large—continues to grow without getting taxed.

So that's how a traditional tax-deductible IRA worked when it was first introduced and still works today. It starts out with a tax break the year you contribute, it protects you from taxes throughout your savings years, and then in retirement you start giving some of the money back to Uncle Sam and your state tax coffers, too.

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