Roth vs. Traditional Accounts
From a tax perspective, there are three noteworthy kinds of events in the life of a lump of money:
- When that money's received as income,
- When it gains net value over the course of the year, and
- When it's withdrawn for use.
Any tax-advantaged retirement account will shield you from paying taxes on annual net gains (that's condition #2).
Whether your account is subject to #1 or #3, though, depends on whether it's a Roth or traditional account.
In a Roth account you'll pay the tax first, when you get the money in your paycheck. The investments grow tax-free. You won't have to pay any additional tax later, when you withdraw from the account in retirement.
Conversely, you don't pay taxes when you contribute to a traditional account, and the money still grows tax-free. Instead, you pay taxes on the money when its withdrawn.
Roth: Pay now. Traditional: Pay later.
Which to choose?
Should you use a Roth or traditional account? Well, if you pay the same marginal tax rate in retirement as you do now, they offer the same yields.
Suppose you've got $10,000 to invest, and suppose that money will be taxed at 30% either now or in the future. Further suppose that you'll be investing that money for 20 years.
Roth: $10,000 X 70% X 1.0720 = $27,087.79
Trad: $10,000 X 1.0720 X 70% = $27,087.79
So why have two different types of accounts? Because it's unlikely that you'll pay the same marginal tax rate in retirement.
If you expect to pay a higher tax rate in retirement (if, say, you expect to keep working your way up the ladder and plan to work until you're in grave) you'd benefit from a Roth. Pay the relatively low taxes now and avoid them later, when they'll be higher.
On the other hand, if you expect to pay a lower rate in retirement (you're making big money now but expect to wind down your career early) you might prefer a traditional account.
TODO: income limit restrictions!
Early Roth withdraw
An additional perk of Roth accounts is that you can, at any time, withdraw your principal without penalty.
So, suppose you contribute $10,000 to a Roth account, forget about it, and after a few years it grows to $30,000. You can chose to withdraw up to $10,000 from the account without penalty at any time.
It's not usually a great idea to withdraw from your retirement accounts, even without a penalty—since you need that money in, y'know, retirement—but it's occasionally the right choice. If you retire before your tax-advantaged accounts become available at 59 1/2, for example, you might withdraw from a Roth principal as a “bridge” to hold you over until the rest of your retirement funds become available for withdraw.