I must be living in a bubble. I thought everyone had a least one IRA or qualified retirement account. Most people I meet have more than one, yet it turns out that only 53% of households with people age 55 and older have a retirement account such as a 401(k) or IRA. This leads me to believe that most Americans are not reading my blog 😊. Okay, I admit that the general population is not as focused on retirement planning as I am, and many folks have trouble making ends meet. However, I also know many workers would save for retirement if they just knew where to begin. To them, I say, start with an IRA.
The next question is: Are you better off with a ROTH or Traditional IRA? Fundamentally, the answer lies in whether you want to pay your taxes now or later. The traditional IRA gives you a current year tax-deduction and tax-deferred growth, followed by taxable withdrawals in retirement. The ROTH works the opposite way. ROTH IRAs require you to pay your taxes up front in exchange for tax-free growth and tax-free withdrawals in retirement.
Many people are surprised to find out that you end up with the exact same number of spendable dollars (after taxes), assuming you are in the same tax bracket when you’re funding your IRA as when you’re withdrawing the funds. So, the old saying, “It’s better to pay tax on the seed than the harvest” doesn’t really hold water…unless you’re in a higher tax bracket during harvest time. Let’s look at an example:
Suppose you are in the 25% tax-bracket and you have $6,000 of gross income to contribute to an IRA. You could put all $6,000 in a traditional IRA, since you would get a tax-deduction and, therefore, not owe any taxes. Alternatively, you could pay your taxes: $6,000 minus 25% = $4,500 and deposit that amount in a ROTH IRA. Remember that whatever the ROTH grows to will all be tax-free, whereas future withdrawals from the Traditional IRA will all be taxable.
|Roth IRA||Traditional IRA|
|Tax on Contribution||25%||0%|
|Investment Returns||7% annual||7% per year|
|Time Invested||20 years||20 years|
|Tax on Withdrawal||0||25%|
The investor in the above example would have been better off with the traditional IRA if he were in the 15% bracket during retirement. This would have yielded $19,735 of spendable income. The advantage comes into play because he took the tax deduction when he was in the higher bracket (25%) and withdrew the funds and paid taxes when he was in the lower bracket (15%).
The opposite would have been true if our investor was in a higher bracket during retirement. For example, an investor in the 35% bracket during retirement would have only had $15,091 spendable, after taxes.
The main advantage of a ROTH only comes into play if you are in a low tax-bracket when you are contributing (early in your career, in between jobs, semi-retired, etc.) and expect to be in a higher tax-bracket in the future. Most people find the opposite to be true. They are in a higher tax-bracket when they are working/contributing and drop to a lower tax-bracket in retirement. In this case, the traditional IRA is a better bet than the ROTH.
That being said, people love ROTH IRAs! They love the idea of tax-free growth forever and leaving a tax-free inheritance to their kids. Other benefits to the ROTH include the ability to contribute after age 70½ and the fact that there are never Required Minimum Distributions.
Below is a super-helpful chart I created for you. It compares the features of a ROTH IRA vs. Traditional IRA:
ROTH IRAs and Traditional IRAs are both good investment vehicles. They both offer a tax-advantaged way to save for retirement. The tradeoff for getting tax benefits is that these accounts are not considered liquid prior to age 59½. I would argue that is a good thing. The early withdrawal penalties deter people from raiding their IRAs to pay off credit cards, take vacations, or buy new cars or houses that are out of their budget. The largest assets most Americans have are their houses followed by their qualified retirement plans or IRAs…both illiquid assets that involve systematic savings and tax-advantages.
To learn more about this topic, read: FAQs regarding IRA Contributions.
Give us a call or hit “reply” to this newsletter if you have any questions about which IRA would be the best for you…or whether you should convert your traditional IRA to a ROTH.
Have a great 4th of July weekend and stay cool!