01 Feb Traditional IRA vs. Roth IRA
When looking into the future, all the way to retirement (yikes, that’s a ways), you have likely heard the term “IRA.” With that term, you have also probably heard “traditional IRA” and “Roth IRA.” They sound like they do the same thing, so what is the difference? We are going to take you through what an IRA is, the differences between a traditional IRA and a Roth IRA, why they are important, which one is right for you, and how you can become a MILLIONAIRE! Buckle up, here we go!
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What to Remember
The main difference between traditional and Roth IRAs is when you pay taxes. With traditional IRAs, you skip the taxes now and pay them later. With Roth IRAs, you pay taxes now and skip them later. Depending on your income levels today and in retirement along with your expected life expenses, you will be able to calculate whether a traditional or Roth IRA is better for you and why it matters.
What is an IRA?
Before we go into the differences among IRAs, we first need to know what an IRA is! IRA stands for “Individual Retirement Account.” It is a tax-advantaged account that helps people build long-term savings for retirement. What does that mean? Essentially, you are making a nest egg that will grow over time and be ready for you when it is time to retire (age 59 ½).
You Can Become a Millionaire
Yes, you read that title correctly! You can become a millionaire! Let’s do some quick math together. Let’s say that starting at age 18, and you put $400 a month in an IRA account. Assuming that you will earn a 7% return (the typical average over time), that means that your contribution and earnings will be over 1 million dollars by the time you are 59 ½. WHOA!
Let’s bump it up a notch and say that you are a real go-getter. You make sure to deposit the maximum amount ($6000) each year, starting at age 18. Again, assuming a 7% return, you will have over 2 million dollars by the time you are 65! HOLY COW!
That’s awesome, but how do I do that? And what if I am older than 18? To get yourself on the right track to becoming a millionaire, you have to decide whether to invest in a traditional IRA and a Roth IRA and we are going to help you figure out which one is right for you! Let’ do it!
Similarities between a Traditional IRA and a Roth IRA
Traditional IRAs and Roth IRAs have many of the same basic features. As of 2020, you are allowed to contribute $6,000 per year to the fund; if you are over 50, you can contribute $7,000 to each type of account. In these accounts, your money will grow over time because it is invested in a variety of stocks, bonds, mutual, and index funds. Don’t worry too much about that because with IRAs, you have to have it done through a brokerage company of some sort! It is not a DIY thing.
What is the Difference?
Pre-Tax vs After-tax Contributions:
The main difference between a traditional IRA and a Roth IRA is what kind of money you contribute with, pre-tax or after-tax money. In a traditional IRA, you contribute pre-tax money. This means that you can save money on taxes now, and it could put you in a lower tax bracket now. A Roth IRA is the opposite; here, you contribute after-tax money. This means that you can save money on taxes later, and it could put you in a lower tax bracket later. Essentially, the difference is with a ROTH IRA you are paying taxes on the money now (before the money is invested) and with a traditional IRA, you are paying taxes later (when you withdraw the money).
The second difference between the two is withdrawals. In a traditional IRA, if you withdraw the funds you contributed early (before 59 ½ years old), you have to pay a 10% penalty as well as taxes. OUCH! On the other hand, with a Roth IRA, if you withdraw early, there is no penalty, and you don’t have to pay taxes on it.
Note: If you were to withdraw from either IRA early, you can’t put the money back in. Once it’s out, it’s out. You can put in $6,000 ($7,000 if over age 50) max each year, no matter whether you withdrew some or not.
The third difference is the distribution age. In both accounts, you can start distributing the money (taking it out to use in retirement) at age 59 ½. Now let’s say that you are still working, you have other savings, or you are earning passive income, you may not want to take the money out yet because you don’t need it. That would be awesome! Sadly, in a traditional IRA, you MUST start distributing the money by age 70 ½, whether you want to or not. However, in a Roth IRA, you don’t have to do that; you can wait as long as you like to start distributing funds.
Who Can Contribute
Lastly, the fourth big difference between the two is WHO can contribute. In a traditional IRA, anyone can participate. In a Roth IRA, that is not the case. Depending on how much money you earn, it affects the amount you are allowed to contribute. If you make over $122,000 as a single person, the contribution amount allowed will start whittling down. So, if you are making a bunch of money, you may not be able to contribute as much as someone making less than you.
We understand that that was a lot of information, so here is a table to break down what we just said quick and easy.
|Traditional IRA||Roth IRA|
|Contributions are invested tax-free||Contributions are taxed before investing|
|Fund withdrawals are taxed as income (at the income tax rate of your income at withdrawal)||Withdrawals are made tax-free|
|Will help you be in a lower tax bracket now||Will help you be in a lower tax bracket later|
|Distribution at age 70.5||Distribution whenever you want|
|Early withdrawal of contributions = taxes + 10% penalty||Early withdrawal of contributions = No taxes, no penalty|
|Any income bracket can contribute||Income affects the contribution amount|
Why Does This Matter?
At this point, you may be wondering what the point is, why should you care about tax brackets now versus later? To explain, let us paint you a little picture about the life of two very different people.
IRA Example #1 – Carol Comfy
Our first person is Carol Comfy. Carol is a hotshot lawyer in LA who makes a lot of money, we are talking well over six figures every single year. She is expecting that over the next few decades she will work hard at her job, pay off her house, invest heavily in her 401(k), build up her stock portfolio, and retire at the normal time. Right now, she has a fancy house, stylish cars, and college funds set up for her kids. However, this isn’t the life that she wants forever. When it comes time to retire, Carol wants to move out of the big city to a mountain town where we can enjoy her golden years in a comfy cottage that is peaceful and relaxing.
So which IRA account should she choose? Carol should choose the traditional IRA account. Why? Remember, Carol is making a lot of money now with the expectation of making little money during retirement. Since she is in a high income bracket now, this means that she would want to be taxed later when she is expecting to be in a much lower income bracket (saving her money both now and later). Plus, since she makes so much money, she could want a retirement account that allows her to contribute the full amount each year. AND since she’s financially stable, she is likely not going to need to withdraw any funds early.
IRA Example #2 – Eric Elegant
Now, let’s look at our second individual, Eric Elegant. Eric is a 25-year-old entrepreneur with big dreams of the future. He is still paying off student loans and makes around $35,000 a year. He lives with roommates, has a pretty tight budget, and is investing whenever he can. Eric plans to one day leave the “just getting by” lifestyle behind, and to have a luxurious early retirement. We are talking about a house on the hill with a pool, vacationing around the world, and enjoying everything that money can buy. These aren’t just fantasies; Eric’s business model is expected to expand into a billion-dollar operation in the next couple of decades, so all of this will become a reality for him.
So which IRA account should he choose? Eric would want to choose the Roth IRA account. Why? Remember, Eric is currently not making much money which puts him in a lower tax bracket, so he should pay the taxes now when they are cheap versus later when he will be in a much higher tax bracket. Since he isn’t making much money, he won’t have to worry about how his income affects his IRA. Plus, if Eric needs his contributed money back to fund part of this business venture, he could pull it out of this Roth IRA if needed without penalty. Then when his business is a success and it runs itself, he can retire early and access his Roth IRA whenever he wants.
The whole point is that by choosing the proper accounts for the lifestyle that they are expecting, Carol and Eric will end up savings tens of thousands of dollars in the long run. You want to do the same thing. We understand that thinking decades into the future can be difficult, but it is likely that you have a broad idea of what you want your life to turn out to be. To help you figure this out, we will go through a few questions with you.
Which IRA Should I Choose?
Obviously, both accounts offer pros and cons but knowing which one is right for you can be tough. Here are a few questions you should ask yourself:
- How much money am I making now?
- What will my income be when I retire?
- Do I want to pay taxes now or later?
- Do I want to be in a lower tax bracket now or later?
- Am I going to need to withdraw that money before my retirement?
- When am I estimating that I will need to start withdrawing for retirement?
Let’s take a moment to analyze some possible answers.
Are you rolling in cash, or are you making less than $122,000 a year? If you are making money rain, a traditional IRA is the way to go because it doesn’t have income limits. If you don’t see yourself making six figures a year, then either account will work.
2. Retirement Income:
Will you still be making money during retirement from rental properties, royalties, or other methods? Is it going to be a lot of income or just a little extra? Calculating this will help you determine which tax bracket you will be in during retirement (see #3 and #4).
If you prefer to pay taxes later, you should choose the traditional IRA. If you can afford to pay taxes now, you would likely go with the Roth IRA.
4. Tax Bracket:
If you would prefer to lower your tax bracket now, you would want to choose the traditional IRA. Keep in mind that this will only help you if your contributions tip your over the income bracket threshold to a lower level. For example, there is a 22% rate for incomes over $40,125. So, if you were making $43,000 a year, and you contributed $6,000 to your traditional IRA, that would bump you down to the next tax bracket down which only has a 12% rate. But, if you can’t tip the scale, then it wouldn’t do anything for you.
If you are unsure of what tax bracket you will be in the future and want the possibility to lower it later, you would choose a Roth IRA.
5. Early Withdrawal:
If you are not planning to use any funds that you contributed ever, either account will work for you. However, If you are planning on buying a home, starting a business, or some other situation where you will need starting capital, you may be thinking of using some of your IRA. If that is the case, you wouldn’t want a traditional IRA because of the penalties and tax obligations. Instead, you would want the Roth IRA.
Remember that with both accounts, you can start withdrawing funds at age 59 ½. With a traditional IRA, you HAVE TO start pulling funds at age 70 ½, whereas with a Roth IRA, you can wait as long as you like. Now, we understand that retirement may be a ways in the future and is hard to think about, but if you don’t believe that you will need funds by age 70 ½, you would want to go with the Roth IRA. However, if you feel that you will want funds before that, then (again) either fund works.
Start an IRA Now!
Pause, we have a real quick disclaimer. That was a pretty cut and dry list, and every individual has unique plans and future needs. That is why we suggest chatting with an investment manager so that they can help you make an informed decision based on your personal needs.
Now, do you remember when we talked about becoming a millionaire at the beginning of the article? We know that our example started at age 18, which is the best time to start. However, if you are older than 18, don’t fret. You just need to get started now. “Why?” you ask? Great question!
The reason why you want to get started now is because of compound interest. Basically, the interest your money makes will grow exponentially. The longer it has to grow, the faster it will add up. Therefore, starting as early as possible will make you more money than if you were to wait. It is like a money snowball rolling down the hill to financial success!
It seriously takes 20 minutes online to get started, and you can do it right from the couch! You don’t even have to go to the bank. A few options to start an IRA would be through Fidelity, Betterment, or Charles Schwab. You can also create one through local brokerage companies if you would like to talk to someone face to face. No matter how you get started, the important thing is just getting started! Start down the path to be a millionaire today!
401(k) vs. IRA?
As we are wrapping this up, you may be asking yourself, “but wait…what about 401(k)s?” If you did, go you! 401(k)s are another long-term retirement investment option that you should consider doing in addition to your IRA. Please read our next article on the different types of 401(k)s! If you are unsure if you should invest in a 401(k) or an IRA, here is an article on it just for you!