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Traditional IRA vs Roth IRA

In this episode of The Stewardology Podcast, we weigh the strengths and weaknesses of two great retirement savings contenders: The Traditional IRA vs Roth IRA. In reality, both are valuable tools to use when saving for retirement. However, they both have unique tax advantages to consider before deciding which vehicle to use.

 

What is an IRA?

An IRA (Individual Retirement Account) is an investment vehicle that offers tax advantages as you save for retirement. There are different types of IRAs (Roth & Traditional) that offer different kinds of tax advantages.

 

Traditional IRA vs Roth IRA

This is really the difference between pre-tax and post-tax investing. 

  • Pre-tax means that none of the money invested has ever been taxed. This is how a Traditional IRA or a standard 401(k) works. While funds remain in the account it is sheltered from taxation. Capital gains distributions, dividends, buying and selling shares are not taxed. Only once the funds are withdrawn from the account is there a taxable event. All withdraws are taxed as ordinary income. 
    • Fred earns $50k at work and contributes $5,000 to an IRA. He gets to deduct the $5k from his income and is taxed on only $45k. 
    • In retirement (any time after age 59.5), Fred withdraws $12k from his IRA to supplement income. This/these withdraw(s) are subject to taxation as ordinary income. He will receive a 1099-R showing the amount withdraw from the IRA and how much, if any, was remitted to the IRS. If has 10% tax withholding (federal only) $12k gross turns into $10,800 net ($1,200 sent to IRS).
  • Post-Tax means that all contributions to this account has already been taxed as ordinary income.  The funds invested in this type of account can then grow entirely tax free. This is different from the Pre-tax or Traditional IRA which is only tax deferred. In retirement, all funds withdrawn are done so tax free. 
    • Mary earns $50,000 a year and contribute $5,000 to her Roth. She gets taxed on $50,000. There is no deduction for the contribution to her Roth.  
    • In Retirement (the later of age 59.5 and 5 years after opening Roth), Mary takes $25k from her Roth to purchase a new car. She gets to full $25k and has no tax withholding. The 1099-R shows it as a tax free distribution. 

 

Key Differences (Content from Investopedia)

  • Both Traditional IRAs and Roth IRAs provide generous tax breaks. The difference comes in the timing of when you can claim them. Traditional IRAs provide the tax break today whereas, Roth IRAs provide the tax break in retirement. 
  • Another Key difference is RMDs (Required Minimum Distributions). With traditional IRAs, RMDs must begin when you reach age of 72 even if you don’t need the money. The size of the RMD is based on the Dec 31st account value of the prior year and your life expectancy. Note that RMDs are only required on Traditional IRAs. Roth IRAs are not subject to RMD requirements.

Traditional vs Roth IRA

  • RMD Withdraw rates 
    • Age 72 = 3.65% (Was 3.91%)
    • Age 75 = 4.07%
    • Age 80 = 4.95%
    • Age 85 = 6.25%
    • Age 90 = 8.20%
  • Pre-Retirement Withdrawals
    • Traditional IRA withdraws prior to age 59½ are subject to a 10% early withdrawal penalty in addition to ordinary income taxation. . You can avoid the penalty (but not the taxes) in some specialized circumstances: 
      • If you use the money to pay for qualified first-time home-buyer expenses (up to $10,000) or qualified higher education expenses. 
      • Permanent disabilities and certain levels of unreimbursed medical expenses may also be exempt from the penalty, but you’ll still pay taxes on the distribution. 
    • Roth IRA allow you to take up to 100% on the total amount of money contributed to the account penalty- and tax-free at any time, for any reason, even before age 59½. If you want to withdraw earnings, you can avoid taxes and the 10% early withdrawal penalty if you’ve had the Roth IRA for at least five years and at least one of the below circumstances applies to you: 
      • You are at least 59 ½ years old.
      • Have a permanent disability.
      • You die and the money is withdrawn by your beneficiary or estate.
      • Use the money (up to a $10,000-lifetime maximum) for a first-time home purchase.
    • If you’ve had the account for less than five years, you can still avoid the 10% early withdrawal penalty if: 
      • You’re at least 59 ½ years old. 
      • The withdrawal is due to a disability or certain financial hardships. 
      • Your estate or beneficiary made the withdrawal after your death. 
      • You use the money (up to a $10,000-lifetime maximum) for a first-time home purchase, qualified education expenses, or certain medical costs.

Comparing Roth IRAs and Traditional IRAs

Chart from Investopedia

Why do I need an IRA (Traditional or Roth)?

  • You would open a Traditional IRA when rolling over money from an employer retirement plan, such as a 401k or 403b. This would allow the transaction to be tax deferred.
  • You would use a Roth IRA when you want to start growing your wealth tax free for retirement or when you are rolling over after-tax money from an employer sponsored plan.

When should I start an IRA (Traditional or Roth)?

As we have mentioned on previous episodes, the sooner the better! The earlier you start, the more time compound interest will have to work its magic. The earlier you start, the more you can save over time! As long as you have earned income, you can open a Roth IRA as a child provided the child has earned income.

Is the Traditional IRA or Roth IRA right for you?

When thinking about the competition between the Traditional IRA vs Roth IRA, this is a great question to ask. You should consult a financial advisor and tax professional with your specific situation. In general, I recommend the Roth IRA (provided you meet the eligibility criteria) for the long term tax benefits. 

  • Consider the compounding effects of contributing to a Roth IRA for 30 years. ($6,000/yr for 30 years at 8%/yr)
  • You will have contributed $180k (and already paid taxes on it).
  • at 8% a year, your contributions grow to $745,179.72. 
  • That means, you would have over $565,000 of tax free growth.

 

 

Next Steps

 

 

Episode 082: Traditional IRA vs Roth IRA is property of The Stewardology Podcast, a ministry of Life Financial Group and Life Institute. You may not copy, reproduce, modify, create derivative works, or exploit any content without the expressed written permission of The Stewardology Podcast. For more information, contact us at Contact@StewardologyPodcast.com or (800) 688-5800.

The topics discussed in this podcast are for general information only and are not intended to provide specific investment advice or recommendations.  Investing and investment strategies involve risk including the potential loss of principal. Past performance is not a guarantee of future results.

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