July 23, 2024
Unpacking the Roth IRA and how it compares to its cousin, the Traditional IRA.
Hello, everyone. Welcome back! You're watching another episode of Money Fundies. My name is Matt Stearns, and you're here at Millennial Money Management. If you missed our last episode, we did a little on-site shooting at Chautauqua Lake in New York for our Fourth of July special. We talked about credit cards and how they can be an asset in our financial flexibility.
Today, we're gonna go back to the investment realm and talk about a very popular topic, and a topic of much confusion, which is the difference between a traditional IRA and a Roth IRA. What separates them? What is appropriate for each individual? And really just the fundamentals behind all the qualifications and rules associated with each one.
Okay, so IRA stands for Individual Retirement Account. You can have these in addition to a 401(k) at work. Okay? So, these are plans you can set up on your own or with an investment advisor like myself if you're more comfortable doing so. They’re essentially a brokerage account with tax advantages that the IRS offers as an incentive to get people to save for retirement, and they each have different incentives when it comes to their tax savings.
But within these accounts, you can basically choose nearly an unlimited number of investment options. So, I can put in the same investment options that I would put into a standard investment account. So, as far as flexibility and the ability to go to portfolio, it's still very conducive to however you want to go about building it.
Okay, but first, we'll start to talk about traditional IRAs, and they're the oldest type of IRA, and then to the Roth accounts. So, to begin with, what both of these accounts have in common are contribution limits personally. So, each year you can contribute up to $5,500, and if you're over 55, the IRS allows you to contribute $6,500. Okay? And then they also become qualified, which means we can take distributions from them, assuming we fit a couple of other criteria that I'm not going to go into in this video. But for the most part, if you're fifty-nine and a half years old, you can take your money out of your IRA without penalty.
Okay, and then, of course, you have to pay the appropriate taxes depending on which account you use. All right? So, those are similarities between both accounts.
All right, when we talk about a traditional IRA, now it's what we call a pre-tax account. Okay? So, both Roth and traditional IRAs function the same way from the onset. So, typically what you'll do is you will have— you'll get your paycheck or your salary, and let's say you've put aside, you know, a couple thousand dollars to contribute to your Individual Retirement Account. Well, in both situations, you've already paid taxes as they've gotten pulled out of your paycheck. Okay? Assuming you’re getting a traditional, you know, salary paycheck from your employer, okay?
In that situation, if you take that money and put it into either a traditional or a Roth IRA, at that point it's after-tax. You've paid tax on that money because it's already in your bank account. So, what happens with the traditional IRA is when you file your taxes the next year, the money that you contribute to your traditional IRA you get to write off, and it in turn becomes a deduction. So, you deduct it from your taxable income, and as a result, you get a little bit of tax savings or money back from the IRS.
In the Roth account, that money that you contribute, that you've already paid tax on, you don't get any deduction. Okay? So, in the future, all of that money that you put in there you won't have to pay tax on later on. Okay? Because in the traditional, even though we pay tax initially, we got the tax deduction. So, essentially, we contributed that money to our traditional IRA what they call pre-tax.
Okay, so in the future, after we're sixty years old, on a traditional IRA, we'll have to pay tax on all of the money that's in our traditional IRA account. Okay? So, if you contribute two thousand dollars every year, and when you go to retire it's, you know, a quarter of a million dollars, as you take that out, you pay tax on the entire sum.
The opposite of that, the Roth account, is essentially because you're not getting any tax breaks as you contribute the money into your Roth IRA account. When you're sixty years old or you're really ready to take out this money, you can take out the entire amount tax-free, assuming that you fit all the other rules and requirements.
Okay? So, those are the two different options: the pre-tax traditional IRA, you get the tax break every single year as you contribute; the Roth IRA, you get a tax break if you don’t get a tax break on what you contribute, but when you pull out all the money, you’ve paid taxes on what you’ve contributed. But then all of the interest and the compounding growth that happens in the Roth account, you get all those earnings completely tax-free.
Okay? So, you don't have to worry about Ted paying the tax man when you're in your 60s or 70s and want to get this money back. And that point that I just mentioned, all that compounding interest and earnings is the reason why Roth accounts can be so valuable for young people because for a young person that's contributing over 40 years, that compounding interest in the end will represent the majority of the account balance. Okay? It could be as high as 80% of the final balance once, but he is, you know, seventy years old, and the principal, what you contributed with after-tax dollars, would only represent twenty percent.
So, essentially, eighty percent of that money you're never paying tax on, whereas in the traditional IRA system, yes, you get the tax break on the principal that you contribute, that twenty percent, but that eighty percent of growth that you could have, and this is an ideal scenario, you’d have to pay tax on all of that compound growth in addition to that principal. So, that entire balance, you have to pay tax on.
So, that's why you hear the Roth buzzwords so much, especially for a young person. It does take a professional to consider your specific situation, your familial income, you know, if you're single or with your spouse. There are limits on what you can contribute if your income becomes too high, or even your eligibility completely goes away.
And then also, the final factor in really determining whether a traditional IRA or a Roth IRA is best for you is also the need to make assumptions about future tax brackets. So, as a rule of thumb, if you expect to be in retirement and be in a lower tax bracket, when you retire, so right now you're making a hundred grand, and you think that when you retire, you know your income's only going to be fifty thousand dollars between Social Security and whatever other income you might have, typically a traditional IRA would be the better option for you because you don't have to pay tax on that money now while your income's high; you're in a high tax bracket. And in the future, when your income's low, or you’ll be in a lower tax bracket, which is when we have to pay the tax man for a total overall balance as we withdraw it.
Okay? The opposite of that, of course, would be the Roth account. Another reason why it's good for young people is we pay the tax now when perhaps our income is relatively low. Let's say it's $50,000, but we're in a great company. We expect to grow and become manager eventually in 20 years, and then a director. So, when we retire, we're in a much higher tax bracket. This is a typical scenario, obviously.
And then, essentially, we pay tax in the beginning, well, right now, while our income is low and we're in a low tax bracket. So, in the future, when we're a higher earner, and we're retiring and our income's still high because we have, you know, larger Social Security payments and larger, you know, investment income as we retire, then we don't have to pay any tax at that time. We paid it before when we were young and in a lower tax bracket. So, that's when the Roth makes sense.
Okay? So, those two scenarios are what make a Roth so attractive. It depends, of course, you know, on everybody's particular situation. There are circumstances where traditional IRAs can be better for young people, where Roth can be good for older people. There are also planning considerations that need to be made.
Okay? Because with a traditional IRA, for example, you're required to begin taking your money out at the age of around 70. With Roth, you're not required to do that. So, essentially, you know, if you had enough income in retirement, you could pass on your IRA to one of your loved ones, and you would never have to draw on that money and reduce its value.
So, there are multiple things to consider, but hopefully now you have a little bit of background on what differentiates the two and the things that you need to consider when opening an account, whether it be a traditional or Roth IRA. I think it's a great retirement savings account in addition to perhaps if you have something at work, and if you don't have something at work, it's really a must-have. And it's something that, you know, advisors like myself easily facilitate.
You can do it on your own, but realize it takes a lot of experience understanding, not only with making a decision on what account to open, but doing it correctly as far as the taxman so he’s satisfied. And then also, you have to, of course, make the proper investments for the return that you want for your future.
So, at least come in, talk to me. As always, we're very competitive, and in this market especially, you know, being a millennial, I've set up my investment company to service millennials. I start people out from a balance of absolutely nothing. I have a couple of clients that have started individual retirement accounts, and they just started by putting $50 in their paycheck, and they're already seeing their account balances grow with that, you know, consistent contribution.
So, those are things that I can facilitate, but you know, my real purpose today is to make sure that you understand what options are out there and what considerations to make. And of course, if you have any questions, please reach out to me. But that's all I have for today. Thank you for joining me, and of course, we'll see you next time. Thank you!
