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The Only Guide You'll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments by Tiya Lim, Kevin Grogan, Larry E. Swedroe

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Chapter 14. IRAs and Retirement/Profit Sharing Plans

This chapter focuses on retirement accounts. We begin with the decision on whether to invest in a Roth IRA or a traditional IRA.

Roth versus Traditional IRA

Individual retirement accounts (IRAs) are tax-advantaged investments. The two different types of IRAs—traditional and Roth—have some similarities and some differences. The differences have implications for the development of an investment policy statement, the asset allocation decision, and the choice of the preferred vehicle.

Contributions to a Roth IRA are made on an after-tax basis and distributions are not subject to income tax. The traditional IRA is the mirror opposite. It allows contributions to be made on a pre-tax basis (on the tax return the adjusted gross income is reduced by the amount of the contribution), but all withdrawals are subject to taxation.

An example will illustrate both the differences and similarities of the two accounts. Consider two investors, John and Mary. Both are in the 25 percent tax bracket. Both expect to be in that same 25 percent bracket when they retire. They also have the same income and spending needs. They both invest on the same day in the same mutual fund. Each has just received a $1,000 bonus. We'll start with John.

John decides he will invest his bonus in a Roth IRA. Having to set aside 25 percent of his bonus to pay federal income taxes, John makes a $750 contribution to his Roth IRA, investing that amount in a mutual fund that invests ...

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