Traditional IRA vs Roth IRA: What’s the Difference?
Do you have a retirement plan set up?
It’s never too early or too late to plan your retirement and the earlier the better.
There are two IRA options to choose from but before getting into detail about them here are 3 tips to consider.
- Assess your financial situation – make sure you have money to pay for food and a roof over your head first.
- Invest Long Term – the earlier you start the less you have to save monthly.
- Diversify – thinking long term you should diversify in bonds, stocks, 401k, pensions, IRA’s, etc to protect yourself and your retirement savings.
Once you have assessed your current financial situation you can devise a plan to invest your savings into an IRA account.
Quick Definition: IRA stands for Individual Retirement Arrangement
It was created by Congress to encourage retirement saving, allowing the people to make tax deferred investments that provide financial security when they retire.
An IRA account is basically a savings account that you can sock away your stocks, bonds, mutual funds, etc while receiving tax advantages compared to traditional savings.
It will make you more money in the long run due to the tax advantages that Congress implemented.
It’s a type of savings account that you open on your own as well where as a 401k is a company plan and shouldn’t be mistaken.
You can set up an IRA with the following:
- bank/financial institution
- stock broker
- mutual fund
- life insurance company
Traditional IRA vs Roth IRA
It’s important to know there are two different main options when it comes to setting up an IRA.
There is a Traditional IRA and a Roth IRA.
There is also a SEP IRA and a Simple IRA but those deal with small businesses/self employed businesses and will not be covered in this post.
The Traditional IRA
A Traditional IRA has tax advantages over a Roth IRA because your contributions are tax deferred.
This means that you can put money into your traditional account and it won’t be taxed until you withdraw it during your retirement years.
This is key because it allows your dividends, interest payments, and capital gains to compound each year tax free which allows your account balance to grow faster and bigger than if taxes were slowing you down.
Normally your capital gains (such as stocks, bonds, precious metals, and property) are taxed each year but in a traditional IRA account your capital gains are protected from taxation until later.
Your taxable income is also reduced (by up to $458 per month= max contribution of $5,500/year) when you make contributions to your IRA account because the money can be automatically pulled from your pre-tax income lowering your taxable income and saving you more money in income taxes.
As seen in that last paragraph you can have monthly contributions pulled from your paychecks of $458 each of the 12 months to max out your contribution limit of $5,500 per year which will be discussed below.
If couples have an adjusted gross income of less than $60,000, they can claim savers tax credit on their tax returns which can be a credit of $1,000 (individuals) and $2,000 (couples) benefiting them on their taxes as a result of investing in an IRA account whether it’s traditional or roth.
In a Roth IRA your money is taxed before being contributed to your account.
This means when you retire you can withdraw your money tax free.
Sounds nice right.
The only issue is that you’ll usually retire with less money in your account than a traditional IRA. By taxing your money now you have less in your account to compound each year. But it evens out as you’ll see below because that traditional IRA money will get taxed at whatever rate you’re being taxed at during your later years in life and the net money you walk away with won’t be much different.
The following are examples of the difference in your account total upon retirement:
The adjusted gross income has no effect on the calculations.
Assuming a start balance of $0 in your account and maxing out your annual contribution of $5,500,
Contributions starting at Age 18
Starting at Age 25
Starting at Age 35
As you can see the traditional IRA account’s graph on the right is worth more at retirement than the Roth Account on the left in the shorter term.
The Roth is actually higher for the 18 year old who invests for 47 years compared to the traditional IRA.
You can also see that the earlier you start contributing to a retirement IRA (18 vs 25 vs 35) the more money your account is worth by retirement.
This calculator used its own 7% return on investments but a higher rate could substantially increase the retirement accounts value as shown in this article on compounding interest
Feel free to google “IRA Retirement Calculator” and play around with your own numbers and situation.
Other Differences Between IRA’s
Roth IRA accounts have income limits as to who can contribute to them, where as traditional allows anyone.
If your yearly adjusted gross income exceeds the limits then it’s an obvious choice that you have to invest in a traditional IRA account.
An Adjusted Gross Income (AGI) of less than $181,000 (2014) for joint couples or $114,000 (2014) for a single filer can contribute the full amount also known as the max contribution limit to a Roth account.
In 2013 the income limits were lower at $173,000 (joint) and $105,000 (single) which shows you the year over year increases that occur in income limits. This also means if you miss the income limits now maybe in future years the limits will keep rising and you may be eligible.
There is an alternative solution though I’ll discuss below that deals with “converting” that current millionaires are doing to invest in Roth IRA’s still.
Now onto max contributions.
Each year you are only allowed to contribute so much of your money to your IRA retirement account.
401k retirement accounts also have max contribution limits but they are different than IRA’s.
Both Traditional and Roth IRA’s have max contribution limits of $5,500 a year and if you’re over the age of 50 you can contribute $6,500, an extra one thousand dollars due to the “catch up” rule.
In a Roth IRA, you can contribute at any age where as in a traditional you cannot contribute past the age of 70 and 1/2.
To qualify for a Roth IRA account you must have an “earned income” in the year that you want to make a contribution.
Earned income is work that you did that you were paid for.
Wages, salaries, tips, bonuses, commissions are all considered earned income.
Dividends and interest earned from investments do not count as earned income.
You have to make at least $5,500 a year to contribute the maximum to your IRA of $5,500. If you make less than $5,500 like $4,000 for example then you can only contribute a max of $4,000 to your IRA and can’t pull the other $1,500 from savings.
How The Wealthy Invest in Roth IRA’s
Since Roth IRA’s have an income limit as to who can contribute to them, many wealthy people have turned to conversion.
This means they first contribute money to a traditional IRA and then they convert their money from their traditional IRA to their Roth.
This used to not be possible as you could only convert if you had less than a 100k income but in 2006 Congress passed a law that took affect in 2010 allowing all incomes to convert from a traditional IRA to a Roth IRA.
10% of people with incomes above 1 million dollars converted (Wall Street Journal).
You must wait 5 years to withdraw after converting your money due to the 5 year conversion rule.
So you may be asking why so many wealthy individuals are going to Roth IRA accounts when clearly the traditional IRA makes you more money long term.
The answer is that many fear the future tax rates rising.
When you withdraw from a traditional IRA you are taxed based on your income tax bracket at the point of withdrawal.
So years from now the income tax brackets could be higher than they currently are so investors would rather have their money taxed now at the lower rates. But no guarantee either that the rates will be much different years from now.
Another thing to consider is if you are young you will be in a lower tax bracket now than you may be many years from now as you get promoted and so forth. So young individuals may benefit from paying taxes now with a Roth IRA while they are still in the lower tax brackets.
But it is hard to predict what your income and tax bracket will be years from now so it may be best to still go with the traditional IRA because the difference over a Roth in extra income could out exceed the higher taxes you pay years later still netting you more money.
Another reason some like the Roth though is that you can withdraw any time but that involves withdrawing contributions only or else you’ll be charged a 10% penalty if you take out investment earnings before you turn 59 and 1/2.
This means if you have $200,000 in your IRA account and you contributed $80,000 of it and the other $120,000 is investment interest/earnings on your money then you can only withdraw up to your $80,000 of contributions before age 59 and 1/2 without penalty.
Someone who withdraws $100,000 will be charged on that $20,000 extra if they are under the age 59 and 1/2.
Going more into withdrawing money from an IRA
Withdrawing From Your IRA Account
In a traditional IRA you cannot take out any money at all from the account without 10% penalty until age 59 and 1/2 on top of being taxed when you withdraw.
The Roth IRA, again, allows you to take out contribution money anytime but nothing more until age 59 and 1/2 without penalty.
Once someone turns.. you guessed it.. 59 and 1/2 you can take what’s known as “qualified withdrawals” until age 70 1/2 in a traditional IRA.
At age 70 and 1/2 in a traditional IRA you must withdraw from the account, known as “required minimum distributions.” The penalty for missing a required withdrawal is 50% of the amount that was supposed to be withdrawn.
So some people can choose to withdraw or not withdraw upon turning 59 and 1/2 in a traditional IRA but once they hit age 70 and 1/2 they are required to withdraw.
You also cannot make anymore contributions to your traditional IRA past age 70 and 1/2.
In a Roth IRA you can make contributions as long and old as you desire or need to.
Upon withdrawing, again, you’ll either be taxed or you won’t depending on which IRA you are using.
That pretty much covers IRA retirement accounts and if you haven’t created one you should look into it soon.
Many people begin saving for retirement too late and end up having to work longer and more years than planned.
Build those IRA accounts now and when you’re 59 and 1/2 you can retire comfortably living off your withdrawals as well as other stocks, 401K, etc.
In order to contribute to your IRA accounts, learn about Budgeting
The better you budget your money the more you have saved to pay yourself first as discussed in this article, building your IRA accounts.
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