Roth vs. Traditional IRA – What’s the difference?
Many times in life you’re going to find that the devil is really in the details. When it comes to investing, it’s really no different. After all, if you’ve ever read ANYTHING about personal finance, you probably know that you should be investing somewhere between 10-20% of your income each month into a diversified index fund. And if you haven’t heard this, you can click here to learn everything you ever wanted to know about index funds. But that being said, the questions still remains: “Where exactly do I buy these majestic index funds?” And this is where the discussion of Roth vs. Traditional IRA comes into play.
So today is a rare, but often sorely needed, look into the more technical side of finances and investing. Yes, it might be a little scary, but it’s ok: I’ve got your back boo-boo. Ready?
Great, here we go!
What is an IRA?
IRA stands for Individual Retirement Account. Most of what you need to know is right there in the name. The best way I can describe it to you is that there are different accounts that exist for you to put your money in. Each of these can be represented by buckets. You can put your money in a savings account bucket, or put it in a CD bucket, or put it in a stock brokerage account bucket. The issue is, each of these different buckets is going to have different rules when it comes to taxes, penalties, and what/when funds can be withdrawn, etc.
The IRA buckets are what we’re going to focus in on today. The two most common are going to be what’s called a “Traditional” IRA and a Roth IRA. I’m going to go into both in some pretty intense detail, but just know this: an IRA is “bucket” for your money that has specific rules, and benefits.
So first up is the traditional IRA, which has been around since 1974. The thought is pretty simple: you’re allowed to make a certain amount of contributions into this account each year. From there, you can buy stocks, bonds, ETF’s, REIT’s, pretty much whatever you want. However, here is the main advantage of a traditional IRA: the contributions you make can be deducted from your taxable income.
So what does this look like? Well, let’s say we have Janet who earns $50,000 per year. Lets also say for argument’s sake that the $50,000 represents her taxable income. If she contributed $5,000 to a traditional IRA, she can make her taxable income $45,000.
At a income tax bracket of 25%, that would mean Janet saved $1,250 this year in taxes, because she made the right contributions to the right retirement account. Get it, Janet. Get it.
The not so good
Unfortunately, this is pretty much the end for the benefits section. There are a couple other important things you need to know about this bucket.
First, there are some limits as to how much you can contribute. For tax year 2017, you’re only going to be allowed to contribute $5,500. That does get a small bump of $1000 to $6,500 if you’re over 50, but an additional $10-15,000 of investments isn’t going to make a TON of difference in the last decade of your investing career. Well, not nearly as much as it would at the beginning, but that’s math for another time.
So it’s not like you can just contribute as much as you want and reduce your taxes to 0 every year. As AWESOME as that would be.
The second thing you have to be aware of is that there are income limits as well, meaning if you make too much money you’re not going to be allowed to deduct your contributions to a traditional IRA.
Careful, think about that for a sec. You can contribute to a traditional IRA, but after you make a certain level of income, you’re not going to be able to deduct those contributions from your taxable income. See the difference? Basically, you can contribute as much as you want, but the advantage of contributing will go away the more money you make.
The bottom line – Useful, but not great
In the grand scheme of tax-advantaged accounts, the Traditional IRA does alright against the other competitors. However, the current U.S. tax code is structured in such a way that there are literally thousands of deductions you can take.
Well, thousands of possible deductions. Please don’t try to deduct part of your mortgage because of that “home office”. The IRS would love to kick your fanny up and down the streets of D.C. for trying to take deductions you don’t actually deserve.
But with that being said, if there is a pretty easy deduction to take, it’s this one. So use it if it means lowering your tax bill.
But always beware of opportunity cost: Money that’s going into a Traditional IRA is money that isn’t going somewhere else… for example…
The Roth IRA
The Roth IRA is actually the first investment account I ever created. Actually, scratch that: The Roth IRA is actually the first investment account that my dad forced me to create.
The Roth IRA is going to differ in a couple ways from the Traditional. The first, and arguably the most important, is that this “bucket” allows you to withdraw money tax free. I’m gonna say that again for those of you in the back row:
YOU. GET. YOUR. MONEY. TAX. FREE.
Any sort of investment that’s going to allow you to pull out money without the government sticking its hands on it is an investment that gets two thumbs up from me!
This investment “bucket” makes sense for those of us that are going to pay more in taxes during retirement than we do right now. Which when you’re a teacher in Colorado, that’s almost a guaranteed “yes.”
The other advantage is that you can buy pretty much any investment vehicle you want and hold it in a Roth IRA. International stocks, ETF’s, index funds, bond funds, whatever you want, you can pretty much keep it in a Roth IRA.
The Not So Good
As with most things in life, there are certain catches. The first is that you’re only allowed to contribute a certain amount to a Roth IRA every year. As it stands right now, the contribution limit is $5,500 (or $6,500 if you’re older than 50). So no, you can’t take that half of your paycheck and just put it in a Roth.
The other part is that there are income limits. That’s right: Trump, Einhorn, and Icahn are not allowed to invest in Roth IRA’s. It’s just for us normal folks. As it stands right now, you can contribute to a Roth IRA as long as you make less than $132,000 (single) or $194,000 (married). However, these limits are the final point, meaning that you will be phased out of contributing about $15,000 before you hit those income levels.
So… Who wins in the Roth vs. Traditional IRA Battle?
Well, that depends.
(cue readers rising up and revolting with the screaming passion of a eagle on the hunt)
No, it’s actually pretty simple. If you think that your tax rate is going to be higher in the future than it is right now, then the Roth IRA makes the most sense for you. After all, why not try to take advantage of that whole “no-taxes” thing? This would work best for millennials, considering how poor we are anyway! YAY!!! GO US!!!
But, if you’re at a point where you’d rather take the tax savings now, and pay for it later (like if your tax bill is ridiculously high one year) then maybe it makes more sense to make your contributions to a Traditional IRA.
The Wrap Up – Traditional vs. Roth IRA
Listen, here’s the bottom line; as long as your investing in something, and not just leaving the money in your savings account, then you’re doing better than like _____ % of people in the United States. The debate between Traditional vs. Roth IRA really just comes down to your tax needs. Which at some point will become a question for your CPA (unless your boss af and do all your own taxes for the rest of your life.
- Roth IRA – for those who think their taxes will be higher in the future than they are right now. You pay taxes on the contributions, but you don’t pay taxes on the withdrawals. This means tax-free income when you’re old. Aweseomesauce.
- Traditional IRA – for those who need a tax break now. Not nearly as cool as the Roth in my humble opinion, but a very easy way to lower your tax bill if necessary.
Alright readers, you’re up to bat. Do you have any sort of IRA? Do you keep your money in a 401(k) instead? Are you one of the lucky bastards in this world that has an employer that matches contributions? Can you tell that I’ve only worked for employers that don’t? : )
For more from The Code To Riches, check out:
- The Seven Steps to Avoid Being a Money Moron
- The 7 Vegetarian Meals That Are Saving My Budget
- How Much Is Half A Million Dollars?
- The 10 Best Finance Books Money Can Buy
- 9 Credit Score Hacks You Must Know
- Why I Never Want To Retire
- The Laziest Way to Riches – Investing In Index Funds
- Budgeting Basics – Allocating $$$ Like A Boss
- Fuck You, Frugality
- Why A Million Budgeting Tips Will Never Be Enough
Keep trying to crack the code,
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