This posting comes because of a direct request from one of my readers who is also a longtime friend of mine. He reached out personally and asked if I could go into detail about the Roth IRA. I was SO HAPPY when he asked about this because I feel that the Roth IRA is one of the best tools for the average American citizen, especially millennials, to use to aid in achieving financial freedom for themselves and their family.
Not only will I go over the Roth IRA, but I will also discuss the Traditional IRA so you can compare the two and decide which is best for you. I am also going to keep this post as short as possible because in terms of IRA’s, the less language that is provided is usually for the better. People normally get confused between Roth and Traditional IRA’s when someone or some article starts throwing out fancy financial terms that nobody knows, and when they drag the explanation on for too long.
Before I break down the Roth vs. Traditional IRA, let me first define what an IRA is at its core.
Individual Retirement Account (IRA)
An IRA is simply an individual retirement account that you open with a financial institution (Vanguard, Fidelity, Merrill Edge, Charles Schwab), and it allows you to save money for retirement.
An IRA is not an investment by itself…It is simply the vehicle that holds your investments. What I mean by this is that opening/funding your IRA is not the actual investment. The investment is what you place your money in within the account. To further break this down, here are the simple steps towards opening and eventually investing within an IRA:
- Sign up and open and IRA (you can do this online) with a financial institution like Vanguard, Fidelity, Merrill Edge, Charles Schwab, etc.
- Connect your current bank with your IRA, then begin transferring (funding) money over into your IRA.
- Once the money is transferred from your bank to your IRA, the money then typically sits in a Money Market Account. This is the same thing that most use for savings at their local banks when they put their money in a Money Market Savings Account.
- Once your money is finally sitting in your Money Market Account (within your IRA), you then use that money to buy your investments such as stocks, bonds, index funds, mutual funds.
If you are completely brand new to investing and know nothing about the stock market/investments, here is what I recommend you do…
INVEST ALL YOUR MONEY INTO A TOTAL STOCK MARKET INDEX FUND
By investing all your money into a Total Stock Market Index Fund, you are essentially investing your money into the U.S. economy. Your money will be invested in almost every business there is in the U.S., and your money will grow as American business grows.
Money that you put into IRA’s have additional tax-benefits that help you grow your wealth. The major tax benefit you get when putting your money in an IRA is that the growth in that account is TAX-FREE.
What do I mean when I say the growth in your account is tax-free? Let me give you a small example…
Let’s say you invest $10,000 into a Total Stock Market Index Fund at the beginning of 2018. At the end of the year, your investment in the Total Stock Market Index Fund has grown 10%. Your original $10,000 investment is now worth $11,000 because 10% of 10,000 is 1,000, so 1,000 + 10,000 = 11,000. That’s it for the math…
The tax-free benefit of that 10% growth ($1,000) in your investment is that you owe ZERO taxes on that $1,000. In even simpler terms…
THE MONEY THAT GROWS OFF OF YOUR INVESTMENTS CANNOT BE TAXED BY THE GOVERNMENT
Be honest…Are you tired of paying a lot of money in taxes? Do you hear almost everybody around you cry about paying taxes? Well this is one way to build significant wealth while avoiding taxes. As long as you fund your IRA and invest that money within your IRA, your money’s growth will always be tax-free.
Roth IRA vs. Traditional IRA
Now that we understand what an IRA is and the major tax-benefit you receive from it, we can finally break down the difference between a Roth and Traditional IRA. The simple difference between the two is this…
Roth IRA – The money you contribute is already taxed (post-tax), so the money you withdraw from the account at retirement is tax-free.
Traditional IRA – The money you contribute is pre-tax (tax-deductible), so the money you withdraw from the account at retirement is taxed.
I am going to list the major categories/questions that I find most relevant and how they affect both the Roth and Traditional IRA.
#1 – Contributions (Money you put into the IRA)
Roth IRA – Taxed.
Traditional IRA – Not Taxed (tax deductible).
#2 – 2018 Contribution Limits
Roth IRA – $5,500 or $6,500 (catch-up) if you are 50 years old or older.
Traditional IRA – $5,500 or $6,500 (catch-up) if you are 50 years old or older.
#3 – Withdrawals
Roth IRA – Not Taxed.
Traditional IRA – Taxed.
#4 – Withdrawals Can Begin At?
Roth IRA – Any Time.
***Contributions ONLY, not including earnings (growth).
Traditional IRA – Age 59 ½
#5 – Is there a penalty for withdrawals taken before age 59 ½?
Roth IRA – There are ZERO penalties on withdrawals of your contributions. There is a 10% federal penalty tax on withdrawals of earnings (growth).
Traditional IRA – Age 59 ½
There is a 10% federal penalty on withdrawals of both contributions AND earnings.
There are a few more categories that go more in depth on the differences on the Roth and Traditional IRA, and you can find them here. I feel the one’s I listed above give you the best broad picture of the highlights between the two accounts. Would you like to know which IRA Mr. & Mrs. FMM use for their investments?
Mr. & Mrs. FMM Choose…Roth IRA’s
We chose to use Roth IRA’s because of one main reason, and that is we want our money to be TAX-FREE when we begin withdrawing from our accounts. Although a Traditional IRA provides up-front tax benefits in that you can deduct your contributions in the year you contribute, you will owe taxes on all of that money when you begin withdrawing from it. Let’s break this down in an example using Mr. & Mrs. FMM’s current Roth IRA’s…
Mr. FMM has 1 Roth IRA, and Mrs. FMM has 1 Roth IRA. We both max out our contributions every year in our Roth IRA’s, which means we contribute $5,500 every year into both of our Roth IRA’s. We have been doing this for the past 2 years, and each of us has roughly around $11,500 in our Roth IRA’s. Once our contributions are in our Roth IRA’s, we invest ALL of our money into the Vanguard Total Stock Market Index Fund. We invest all of our money into this fund because it represents the entire U.S. Stock Market, and it has an annual return of 9.78% (fund was created in 1992).
Combined, our Roth IRA’s are currently worth around $23,000. We will both continue to max out our Roth IRA’s every year until we turn 59 ½ years old, and we will continue to invest that money ONLY in the Vanguard Total Stock Market Index Fund.
Our investments will have been growing for 35 years (tax-free) with an annual return of 9.78%. After those 35 years when we are both 59 ½ years old, do you want to know what our combined accounts will be worth???
That’s right…Our combined accounts will be worth multi-millions by the time we are eligible to begin withdrawing from them 100% penalty free at age 59 ½. And that’s not even the best part…
Because we chose to use the Roth IRA, that $3,899,544 will be 100% tax-free when we begin withdrawing from it. We will be paying ZERO taxes on any of that money.
What if we chose Traditional IRA’s?
The biggest benefit we would receive if we used a Traditional IRA instead of a Roth IRA, is that we would be able to deduct our yearly contributions from our taxes. This means that both of our $5,500 ($11,000 combined) contributions would be tax deductible, which would lower our taxable income. This would provide us with immediate relief in that we wouldn’t have to pay as much taxes every year come tax season. The Roth IRA’s contributions are NOT tax deductible, so we receive no immediate tax relief during our contributing years. But…
Remember when I said our accounts are projected to be worth $3,899,544? Well, unlike in a Roth account where all the money is tax-free when you withdrawal it, that’s not the same for Traditional IRA’s. Since you essentially took the immediate up-front tax-benefits using a Traditional IRA, you must pay taxes on all that money when you begin withdrawing from it.
Let’s saying the ordinary tax level is 25% in the future when we’re 59 ½ years old. If we used a Traditional IRA instead of the Roth IRA, we essentially then would owe 25% to the government from that $3,899,544. In case you aren’t good at math, that’s $974,886 in taxes…Ouch. Can you imagine having all that money, then having to give close to $1 million back in taxes?
We don’t want to give back close to $1 million in taxes from our multi-million dollar accounts, and that’s why we chose the Roth IRA. We are okay with not getting the up-front benefit of being able to write off our IRA contributions on our yearly taxes by using a Traditional IRA. We want to be able to spend ALL of that money to our choosing when we can touch it, and not give ANY of it back to the government.
If you’re still lost on the difference between the Traditional and Roth IRA, here is the simple breakdown one last time.
Roth IRA – Your money is taxed before going in, and it is NOT taxed when you begin withdrawing from it.
Traditional IRA – Your money is NOT taxed going in (tax deductible), but you will owe taxes when you begin withdrawing from it.