To Roth or not to Roth: Traditional vs. Roth IRAs
Here it is the age old question:
Traditional vs Roth IRA, which IRA is a better choice for you?
Traditional vs Roth IRA, which IRA is a better choice for you?
What applies to both Tradtional IRA:
You need to have earned income in order to contribute to these retirement plans.
What is considered earned income?
Compensations such as salaries, tips, commissions, bonuses, or wages from services rendered.
If all you have are investment income then you cannot contribute to IRAs. The hope is to prevent people with more money to have even more tax advantages over the regular working person. This gives the regular working person to get a leg up in society and build wealth, hopefully.
Let's start with Tradtional IRA:
All contributions are pre-taxed. All the money you put in are sheltered from taxation which can lower your taxable income.
You would choose this if you foresee that you will be in a lower tax bracket in retirement. A lot of people think they're on this boat, but they really aren't.
If you've been socking away tons of pre-tax contributions over your working life, you may end up with millions of dollars (more or less depending how long you ahve been investing) by the time you reach RMD age (required minimum distribution) which is currently set at age 73 years old. Check the IRS.gov for the most current age requirements, because it changes over time.
If you visit the IRS website they give you a calculation of how much you need to withdraw from your pre-tax IRAs when you hit this magical age. If you've been a savvy saver/investor you probably will have to withdraw quite a lot of money which may bump your tax bracket. If you don't withdraw the required amount, you get to pay the IRS 25% (check the website, they change the numbers a lot) of the amount not withdrawn on time.
IRS 1 vs You 0.
The taxes gets worse for you, if on top of that you are not withdrawing from your social security and pension (if you have pension plans). Some pensions are huge, so that alone may already land you on a higher if not highest tax bracket.
If you make way too much, you may even qualify for extra taxes called AMT (Alternative Minimum Tax).
IRS 2 vs. You 0
One of the real problems with people is that very few are far-sighted. It's really difficult to foresee yourself 10-20-40 years from now and see where your finances stand.
Most people I ask, do not know. I always get vague answers.
Let me tell you, ignorance is not bliss, and you will literally pay for it.
If none of these apply to you, then maybe you are better off with a Traditional IRA.
But before you decide read on...
Let's now move onto Roth IRA:
A lot of people who isn't well-versed in retirement plans are very skeptical of Roth.
They all say the same thing: "It's just tax now or tax later between the Roth and Traditional, there is no difference."
There's lots of differences and it really depends on the individual's circumstances. It is not a carte-blance rule.
Did you know your taxes are progressive?
If you earn $120,000 a year (which is really not much at all in California)
You taxes will look like this:
0% on income up to $10,000
12% on income from $10,001 to $40,000
22% on income from $40,001 to $85,000
24% on income from $85,001 to $120,000
So you don't actually get taxed 24% on the entire $120,000.
Yes a lot of people didn't know that.
If you are in between tax brackets, you can choose to invest in a Roth up to the tax bracket limit in order to prevent yourself from moving into a higher bracket.
In order to accurately do this, you should know how much you actually make in a year, by tracking your finances.
In order to be wealthy you can't be lazy with money.
You can even put away a certain amount of money pre-tax to lower your tax bracket but also put in after tax contributions that you can transfer into your Roth IRA via the backdoor or Mega backdoor conversions that I have mentioned in my previous articles.
All you have to do is some easy simple math.
Roth IRAs are exempt from required minimum distributions (RMDs). You can withdraw your investments tax free (just note the 5 year rule of Roths).
You can slowly convert your pre-tax money from your traditonal IRAs, 401k, 403b, and or 457b prior to reaching RMD age (currently 73 years old). Each conversion has its own 5 year clock in Roth, and you pay taxes on those conversions, that's why I said slowly and not all at once. Make sure you know which tax bracket you're currently in and try to stay in that bracket if not below it.
A lot of employers do not allow you to convert your employer sponsored retirement plans until you separate from them, so take that into account as well.
If you don't leave that employer until age 65, then you have less time to move your money into your Roth IRA until age 73. (Less time if you want to not get the sh*t taxed out of you.) If you don't have much money in those accounts it's not as pertinent.
Just remember that life and circumstances change.
If you are just starting out, it usually is better to get a Roth IRA, because your salary may be low enough that maxing out your pre-tax contribution may not lower your tax bracket anyway.
Then as you start to earn more, it becomes more important to balance your contributions between pre-tax and after-tax, for tax efficiency.
That is all for now.
See you on the next one!
-Pam
As a reminder, I created this blog to share information and to increase everyone's financial literacy. This serves as my notebook that I willingly share publicly to help others increase their curiosity and knowledge in wealth building and money management. I am not an official financial advisor, lawyer, or accountant. You will not find legal advice in this blog. Read the full terms and conditions here.
