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I have received a tax free gift of $4000 from a relative. I would like to put the entire amount into a retirement amount but I am not sure as to whether I should put it in an IRA or a Roth IRA. If I understand correctly: If I put it into an IRA, I get a tax deduction for the $4000 (say 25%, so $1000) this year, but I am taxed on that and any gains when I take it out about 20 years from now. (Assume that I am not reinvesting any tax refund as a result of the deduction) Since the deduction balances out the future tax (presumably), I am only paying tax on the gains, however over 20 years, those gains could be greater than the original $4000 itself. (Doubling would only take 3.6% annual return over 20 years )

If I put it into a Roth IRA, I don't get a tax deduction, but I get to withdraw the original $4000 and all the gains, tax free in about 20 years.

It seems the Roth IRA is a better deal tax wise, but I would like to hear if I am missing something.

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    Do you have any earned income? Do you have retirement plans at work? What's your total AGI? Why are you so sure you can even consider Roth IRA contribution?
    – littleadv
    Jun 1, 2015 at 1:11
  • I have a full time job, I have a 401k at work, my AGI is well below the limit for a Roth IRA. Is there any other reason why I shouldn't assume I can make a Roth IRA?
    – chrisfs
    Jun 1, 2015 at 1:21
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    No, then the main question you need to ask yourself is how the tax rate at the retirement compares to your tax rate now. Now you're shaving 25% off. Depending on the tax rate you expect to have in the retirement, check how much gains will make it worth your while to do Roth, and see if it is something you can reasonably expect to gain.
    – littleadv
    Jun 1, 2015 at 1:31

2 Answers 2

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$4,000 is a relatively small amount in the grand scheme of retirement. I think you should decide in general whether a Traditional or Roth makes more sense for you (with the intent that you will continue contributing to it in the future), and then treat the $4,000 like you would any other contribution.

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Since the deduction balances out the future tax (presumably), I am only paying tax on the gains, however over 20 years, those gains could be greater than the original $4000 itself. (Doubling would only take 3.6% annual return over 20 years )

If I put it into a Roth IRA, I don't get a tax deduction, but I get to withdraw the original $4000 and all the gains, tax free in about 20 years.

It seems the Roth IRA is a better deal tax wise, but I would like to hear if I am missing something.

You are missing the time value of money. $4000 now does not have the same value to you as $4000 years in the future. In fact, the $4000 now has the same value as the money it grows into (principal + earnings) in the future. So a certain percentage of tax on the $4000 now has the same effect to you as the same percentage of tax on the $4000 + earnings in the future, no matter how much "earnings" is.

It's simple math. If you start with the same amount of pre-tax money, and have the same flat percentage tax rate, then both Traditional and Roth will leave you with the same amount of money, regardless of how many times the gains are. Try it for yourself.

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