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Roth IRA or Traditional IRA?

by Rob Bertman, CFA, CFP® in Goals, Retirement, Wealth building
May 10, 2016

 

Summary 

One of the major questions that I got after my blog post entitled “Should I Contribute to My Retirement Plan” was, “Rob, what’s the difference between a Roth IRA and a Traditional IRA?”

First of all, thanks for that feedback, because the reason I’m putting out these videos on a weekly basis is to provide you with the financial information that you want to learn about, so that you can feel better and more empowered to take control of your money. Please keep them coming.

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Before we get into the differences between and Roth IRA and a Traditional IRA, let’s start with the 3 major similarities:

  1. Same contribution limits: $5,500 for 2016. Now you can put in $500 this year, $1,000, $2,000, but no more than $5,500 for this year.
  1. Tax-free growth: Once the funds are inside of the IRA, they grow tax-free. Capital gains, dividend and income, are not taxed in an IRA. To me this is the biggest benefit.
  1. Eligible age to withdraw without penalty: 59.5 or older (Why I call these plans my “60+ Money”

There are 2 major differences between a Roth and Traditional IRA.

  1. Tax benefits for putting money in and taking money out. More details below.
  1. Eligibility requirements: Check out the IRS website for income limits and other factors that might make you ineligible to contribute. Just Google “IRS IRA eligibility” then that will get you the page where they explain it. These things change so you want to make sure you’re on top of it.

How IRA Contributions are taxed (when I put money in): Example:

Let’s say that I decide to put $5,000 into a Traditional IRA this year. I get a tax benefit for putting the money into it in the year that I put it in. I can deduct my IRA contribution for that year.

A Roth IRA is flipped. When I put $5,000 into a Roth IRA, I don’t get to deduct that on my taxes, so there’s no tax benefit when I put money in.

How IRA Withdrawals are taxed (when I take money out): Example:

Let’s say I’m 60 years old and I want to take money out of my IRA.

I take $10,000 out of my Traditional IRA, and I’m in the 25% tax bracket. I have to pay $2,500 of taxes on my withdrawal (25% of $10,000). In other words I get to keep $7,500 but I pay $2,500 in taxes on that.

When I pull $10,000 out of a Roth IRA, I don’t pay taxes on that money.  I get to keep that full $10,000.

Now some people say that choosing between a Roth or Traditional IRA depends on if your tax rate is going to be higher or lower in the future. I disagree with that because who knows what tax rates are going to be 20, 30, 40 years from now. I certainly don’t.

My main concern is that the income limits on contributing to a Roth IRA are lower than a Traditional IRA. In other words, as I make more money, I may not be eligible to contribute to a Roth. Once the money is in there, I never have to pay taxes on that money ever again.

I’d rather pay the taxes now and that gets rid of the uncertainty of what tax rates are going to be in 20, 30, 40 years. That’s just me, but you should make your own decision. Please check out the IRS website or talk with your tax advisor to see which would be best for you.

If you like this post or prior posts, please sign up to get these delivered right to your inbox. That way, you don’t have to search for them.  You get them first thing on Tuesday.  Sign up on that gray bar below by entering your first name and your email address.

And also, please connect with me. Please keep the question and feedback because if there are topics that you want to learn about, I want to provide you with that information, because, I want to get you the tools, training, and resources you need so that you can feel confident with your money and do it on your own terms.

Please sign up below, first name and email address to get these coming to you on a weekly basis. I greatly appreciate you taking the time.

Look forward to the next blog next week.

All the best,

Rob Bertman, CFA, CFP®
Founder & CEO
Money With Impact
www.moneywithimpact.com

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Grows taxfree

Future tax rates

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Transcript

Hi there. I’m Rob Bertman founder of Money With Impact, and today we’re going to talk about the major difference between a Roth IRA and a Traditional IRA.

Now a few weeks back, I had a blog post called “Should I Contribute to My Retirement Plan?” where we talked about how contributing to a retirement plan may not be the right thing for you. Most people don’t think, “Should I contribute?” they think, “How much should I contribute?” So if you want to hear more about that, I suggest you go check out that post called “Should I Contribute to My Retirement Plan?”

One of the great things that came out of that were the questions and feedback I got from you, and one of the major questions that I got was, “Rob, what’s the difference between a Roth IRA and a Traditional IRA?” First of all, thanks for taking the time to ask this question and give me that feedback, because the reason I’m putting out these videos on a weekly basis is to provide you with the financial information that you want to learn about, so that you can feel better and more empowered to take control of your money. That’s what I’m trying to do, so thanks again for the feedback and questions. Please keep them coming.

Now another thing along those lines just to be honest is that this is actually my second time shooting this video. I had this video and blog post done, and I was about to post it.  But after reviewing it I thought that it really wasn’t up to the standards that you deserve.  I want to provide you with the tools, training, and resources so that you can take your financial matters into your own hands and on your own terms. And the way that I can best do that is by taking things that are intimidating or concepts that you don’t think you can learn about, and breaking it down so that it’s simple and easy for you to understand. That’s what I want to provide you on a weekly basis, so I went back to the drawing board. I cut out a lot of the stuff that really didn’t resonate. I simplified it, and now I’m ready to give it to you again so anyway. Thanks for the feedback and time, and thanks for the questions. So anyway, let’s jump in here.

Before we get into the differences between and Roth IRA and a Traditional IRA, there are really 3 similarities that we should talk about first. The first similarity has to do with how much money you can put into these accounts in any year (a “contribution limit”). And whether you have a Roth IRA or a Traditional IRA, that number for 2016 is $5,500. Now you can put in $500 this year, $1,000, $2,000, but no more than $5,500 for this year. That’s the first similarity.

The second similarity has to do with how the money grows after it’s inside the account. Whether you have a Roth IRA or a Traditional IRA, the money in that account grows tax-free while it’s in there. When you have a capital gain, or dividend or income which in any other account you might pay taxes on, you don’t have to pay taxes on that in an IRA. To me that’s really the biggest benefit to having these accounts, that it grows tax-free.

The third similarity is the age when you can take the money out without fees or penalties, and that age is 59.5. So as long as you’re 59.5 or older, whether you have a Traditional IRA or a Roth IRA, you can take money out without fees or penalties.

Again the 3 similarities are how much money you can put in in any given year, the second one is that it grows tax-free within both accounts, and the third is what age you can take it out and that’s 59.5.

This 3 reason is why in the “Should I Contribute to My Retirment Plan?” we talked about how I don’t know if I’m going to be retired in 20, 30, 40 years, but I do know that this money is only accessible to me without fees and penalties until I’m 60 or older, so that’s why I call these accounts my 60+ money. Again to learn more about that, check out “Should I Contribute to My Retirement Plan?”

There are 2 major differences between a Roth and Traditional IRA.  The first thing is how you’re taxed when you put money into the account and when you take money out of the account.

The second one has to do with your eligibility to put money into these accounts. Now, I’m not going to go into the details there because the IRS actually has a great website that has all that information. There are income limits that change and there are other factors that make you able to or not contribute to a Traditional or a Roth IRA, and they’re different for both of them.  Learn more about that by Googling “IRS IRA eligibility” then that will get you the page where they explain it. And these things change so you want to make sure you’re on top of it.

Back to the taxes, because that’s the main one I want to cover today. Again the difference has to do with how you’re taxed when you put money in and when you take it out.

So let’s start with a Traditional IRA. This would work just like a traditional 401k or 403b plan that you may have through work. Let’s say that I decide to put $5,000 into a Traditional IRA this year. Now, when I do my taxes, I can take a tax deduction.  In other words I get a tax benefit for putting the money into it in the year that I put it in. Again, once it’s in the account it grows tax-free. When I take money out when I’m 60 years old or older, I pay taxes on that money with a Traditional IRA.

A Roth IRA is flipped. So when I put money into a Roth IRA, if I were to put $5,000 into a Roth IRA this year, I don’t get any tax deduction. There’s no tax benefit to me this year. It grows tax-free just like a Traditional IRA. But then another difference is when I take money out of a Roth IRA, I do not pay taxes on that money.

So again with a Traditional IRA, you put money in and there’s a tax benefit there. You pull money out, you have to pay taxes on the money you take out of it. With a Roth IRA, there’s no tax benefit to putting money in, but you also don’t pay taxes on the way out.

Now you may ask, “Rob which one should I choose?” Well personally, I prefer a Roth IRA, because with a Roth IRA I’ve already paid taxes on that money. I never have to pay taxes on that money ever again as long as it’s in the account, and when I take money out.

I’ll give you an example of how that might work. Let’s say I’m 60 years old and I want to take money out of my IRA. Let’s say I have a Traditional IRA and I take $10,000 out of that account and I’m in the 25% tax bracket. Well, when I take that $10,000 out, I have to pay $2,500 of taxes on the money that I take out (25% of $10,000). So in other words, I take out $10,000 from my Traditional IRA. I get to keep $7,500 but I pay $2,500 in taxes on that.

When I pull $10,000 out of a Roth IRA, I don’t pay taxes on that money.  I get to keep that full $10,000 without having to pay taxes on it.

Now some people say that choosing between a Roth or Traditional IRA depends on if your tax rate is going to be higher or lower in the future. I disagree with that because who knows what tax rates are going to be 20, 30, 40 years from now. I certainly don’t. And so it’s just not worth it for me to even think about that.

I’m thinking that the income limits on contributing to a Roth IRA are actually lower than a Traditional IRA, so I’ll put money into a Roth IRA because my income will hopefully go up. My taxes aren’t a big deal to me when I’m not making as much money. I’ll put money into a Roth. It grows tax-free and I never have to pay taxes on that money ever again.

With a Traditional IRA if I’m not making that much money now, I am using the tax benefit when I don’t need it.

Now, things can change over time, but I just prefer a Roth IRA. And that’s just the way I feel. I’d rather pay the taxes now and that gets rid of the uncertainty of what tax rates are going to be in 20, 30, 40 years.

So anyway, I hope you liked this video, I hope it simplified it for you. The main difference is really how contributions and withdrawals are taxed. I told you that I prefer a Roth, but you have to make a decision that’s right for you.

If you like this video, or if you’ve been watching these over the past few weeks, please sign up to get these delivered right to your inbox so you don’t have to search for them, and that you get them first thing on Tuesday.

Sign up on that gray bar below by entering your first name and your email address. That way, I’ll send it right out to you on Tuesdays so you don’t have to go searching for it, and you can keep getting this information.

And also, please connect with me. Please keep the question and feedback because if there are topics that you want to learn about, I want to provide you with that information.

Again, I want to get you the tools, training, and resources you need so that you can feel confident with your money and do it on your own terms, so keep them coming.

Please sign up below, first name and email address to get these coming to you on a weekly basis. I greatly appreciate you taking the time. Look forward to the next blog next week.

All the best,

Rob Bertman, CFA, CFP®
Founder & CEO
Money With Impact
www.moneywithimpact.com