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Roth vs traditional: Cramer’s rule of thumb

(Click for video linked to a searchable transcript of this Mad Money segment)

People often ask Jim Cramer if it's better to put money in a traditional retirement account such as a regular IRA or if it's better to invest in a Roth IRA. Of course the answer really depends on your circumstances.

But largely the "Mad Money" host says there are some simple rules to follow that will ultimately help you make the decision.

Background

Although many of you may be familiar with the differences, if you're not, here's a little background.

Traditional IRA: "A traditional IRA lets you take pre-tax income, invest it, with gains compounding year after year, decade after decade," Cramer said. "But you pay tax on the money later in life

Got that? A traditional IRA allows you to invest pre-tax dollars and then pay taxes later.

Roth IRA: A Roth IRA works differently. "With a Roth, you make contributions with after-tax income. Once your money is in a Roth IRA, it grows tax-free."

Again, a Roth IRA allows you to invest post-tax dollars and never pay taxes on it again.

Now, which is right for you?

Justin Pumfrey | Iconica Getty Images

Cramer's rule of thumb

First, there are some restrictions involving a Roth IRA. For individuals you have to make less than $122,000 a year; couples have to make less than $178,000.

However, if you do qualify, then Cramer says making the decision effectively boils down to how you answer the following question:

"Does it makes more sense to pay income tax now with a Roth, or to wait and pay income tax once you've retired, with a traditional IRA?"

Here's how Cramer would answer that question.

"This is my quick rule of thumb. For anyone whose marginal tax rate is 25% or less, which is most of America, I think you go with a Roth. Better to take the hit up front, and allow your Roth IRA to compound tax free for the rest of your life."

Cramer believes the long-term benefits are significant.

"As long as your cash remains in the account, you don't pay capital gains tax, you don't pay dividend tax, and when you withdraw it, which you can do without penalty after the age of 59 and a half, you don't pay any income tax on your withdrawals."

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In the long-run Cramer thinks the majority of Americans will come out ahead. "Even if you just park your retirement money in a low-cost index fund that mirrors the S&P 500," Cramer said, the Roth will be the better vehicle for most people.

"In this case. the bottom line is simple: The lower your present income, the more you'll get out of a Roth IRA," Cramer said. "It's just that simple."

Call Cramer: 1-800-743-CNBC

Questions for Cramer? madmoney@cnbc.com

Questions, comments, suggestions for the "Mad Money" website? madcap@cnbc.com

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