Roths grow tax-free
To make the clearest (simplest) case for IRA, let's consider the ROTH IRA. This was developed to answer some problems with traditional IRAs. Comparing "Roth IRA" to "normal investments" will illustrate the situation very well.
Ron earns $5000 and puts it in a Roth IRA. Norma earns $5000 and puts it in a brokerage account. Both of them are investing money they already paid taxes on, which makes this comparison easy.
Both buy the same index fund. Over 40 years, their $5000 grows averaging 8% a year, to $110,000. They sell their index funds.
Norma fills out Schedule D, listing a "Cost Basis" of $5000, "Sale Price" of $110,000, and "Proceeds" of $105,000. Unfortunately in the ensuing 40 years, capital gains tax rates aren't so great, and Norma pays 25% State and Federal tax, or $26,250, on the gains.
So, Norma collects $83,750.
Ron collects $110,000 in proceeds. That's it. End of story.
Now do you understand the value of a Roth?
Except it's worse than that.
Because neither of them sits in the same index fund for 40 years. They buy and sell, "rebalance" their portfolios, so on average any given asset gets exchanged for another every 5 years. That means that Norma gets pinched for capital gains taxes EIGHT TIMES, diluting Norma's profits further.
Ron does the same asset swaps, but does not pay any capital gains tax because the assets are inside an IRA.
Traditional IRAs enjoy the same benefit... kinda.
With a traditional IRA, you are not taxed when you contribute the money, but you are taxed when you withdraw it. Since you weren't taxed "on the way in", you can contribute more.
So for instance, if Ron and Norma above were in a 30% combined tax bracket, they had to earn $7142 in order to have $5000 after taxes to contribute to their Roth and brokerage accounts, respectively.
How about Trish, who doesn't pay tax on the $7142 and contributes it to a Traditional IRA (ignoring contribution limits; say Trish uses a 401(K) which works the same way). What happens to Trish?
Again assuming 8% average growth, Trish is at $155,000 after 40 years. Since it's a Traditional IRA, Trish must pay 30% normal income tax "coming out of it". This is a worse rate than Norma, but it starts with more money. So with $45,000 taxes paid, Trish is right back at the same $110,000 as Ron.
Trish does the same asset swaps, but does not pay any capital gains tax because the assets are inside an IRA.
With mathematics alone, Traditional is equivalent to Roth
However, there are very significant non-math complications that make Traditional IRAs an inferior choice.
Somewhere in another answer here I have an extensive list. But the first and biggest problem relates to tax brackets. The general concept is you're supposed to be able to withdraw a Traditional IRA funds at a lower tax bracket, because you're supposed to be making less money per year when you're retired. And also assuming tax brackets aren't raised, either by government action or by the creep of inflation.
The idea is you're supposed to withdraw IRA funds evenly from age 59-1/2 to end of life. Easy as pie, right? All you need to do is know your death date. Because, you see, the whole plan falls apart if necessities oblige you to withdraw a great deal more money in certain years. That drives you into a high tax bracket in those years, and generally speaking, you get creamed on taxes.
And unfortunately, that is life in retirement these days. At least you or your partner is very likely to have a slow, lingering endlife with lots of care needed that isn't paid by Medicare. So a traditional IRA leaves you two bad options:
- Withdraw at a faster rate than is ideal, and thus, pay more taxes than are ideal.
- Be driven into very high tax brackets in years when medical crises necessitate large withdrawals.
By contrast, a Roth has no "coming out" taxes, so it's very friendly to the "withdrawal spike/surge" scenarios.