Part of the scope of this blog is to discuss and educate in the area of health, wealth and wisdom. I’ve somewhat been neglecting the area of wealth. Likely because my day job is that of a financial planner so I’m always doing those things throughout the week and use this as an outlet to discuss my other passions of health and philosophy. I am going to start putting more energy into the area of wealth because it is important and something I value. Some topics will bee very in depth and may go over your heads. But most will be the basics of finance, wealth creation, and management. One of the questions I get quite often is a misunderstanding of the difference between a Traditional IRA and Roth IRA. Both of these plans are Individual Retirement Accounts (IRA). They are independent of retirement accounts that you have through work (401(k), SIMPLE IRA, 403(b), etc.). They both have restrictions to them that are similar. You are limited to how much you may contribute to either. If you’re under 50 you are limited to $5,500 per year. If you are 50 years old or older then you may contribute up to $6,500 per year. You must have earned income of up to that dollar amount in order to contribute.
There are income limits to be able to contribute to a tax deductible Traditional IRA. Assuming you don’t make too much money, you are able to deduct that $5,500 contribution off of your taxable income for that year. So, if you made $60,000 for the year and contributed $5,500 to your Traditional IRA then your taxable income, before any other deductions, is $54,500. That contribution you made can be invested however you so choose. You can put the enitre amount in a savings account, buy gold, put it all in Facebook stock, or create a well diversified portfolio; it’s up to you to be as aggressive or conservative as you wish. Once you make that contribution is inside the Traditional IRA all of that growth that occurs in the account will grow tax-deferred, meaning you do not pay tax on any of the gain until you startto pull funds out. This allows for one of the greatest forces in the universe, conound interest, to do it’s thing. You get that growth snowballing on itself until you start taking money from the account. The IRS doesn’t allow you to take funds from your IRA until you are age 59.5 without a 10% penalty (there are some exceptions to this but difficult to do) so if you pull funds out early then you owe 10% on what you pulled out and it’s all taxable as well. Once you are 59.5 years old then you may pull out funds without the penalty but every cent you pull out will be taxable. At age 70.5 the IRS will force you to start pulling out a certain percentage of your Traditional IRA and paying the tax on it, these are called Required Minimum Distributions.
Like aTraditional IRA, a Roth IRA has income limitations to be able to contribute (see the link below for limits). The contibution dollar amounts are the same in a Roth as a Traditional IRA. Only difference is that you do not deduct your contribution the year that you contribute. So, if you earned that same $60,000 and contribute $5,500 to your Roth IRA then your taxable income that year (before other deductions) is still $60,000. Liek a Traditional IRA you can invest your Roth IRA however you so choose. Now, the differentiator of a Roth IRA and what makes it so cool is that you still get that tax-deferred growth and the compounding of that growth over time BUT when you begin taking withdrawals from your Roth IRA all of that growth, that you’ve never paid tax on, comes to you completely tax free. Also, it has more flexibility for early withdrawals. You can always take out what you’ve contibuted to your Roth IRA at any time without penalty but if you wanted to take out the gain inside the account then you’ve got the same rules as the Traditional IRA in terms of penalties and taxes. Once you are 59.5 then you can get to your entire account completely tax free. Also, there are no Required Minimum Distributions at 70.5, you can keep this account untouched as long as you’d like.
Which should I use?
This is where I have to punt a little bit and put on my “Planner” hat. Every situation is different. As a general rule, if you’re in a relatively low tax bracket then I really love the Roth IRA. If you’re in a higher tax bracket and are still able to deduct your contribtion then I like the Traditional IRA. However, thats not always true, there are a million factors to consider; do you own your own business, are you able to do a non-deductible Traditional IRA, how do your emergency reserves look, do you have an employer retirement plan available, does it have a match, etc. But as a general guideline its a good place to start.
As far as how to invest inside these acounts, I am not going to get into that in this post, look for later posts for that or talk to a planner to help you out with making sure you are invested appropriately.
This post doesn’t cover all the ins and outs but is meant to cover the basics. If you have anything to add I, and others, wouuld ove to hear your input tso pleasse comment. I hae poste a couple of links to IRS guidelines below.