An IRA, or Individual Retirement Arrangement, as defined by the IRS, is a “tax-advantaged personal savings plan.” Unlike a savings account, though, any deposits, or “contributions,” you make to these savings plans are are not typically readily accessible for withdrawal, or if they are, can have some pretty hefty penalties if done incorrectly or at the wrong time. Allow me to elaborate.
Contributions made to an IRA typically, or at least as a general rule, should not be withdrawn from until you reach retirement age of 59 1/2 years old. Of course, there are exceptions, which we will go over a bit later. But it’s important to remember that you can’t typically just deposit and withdraw money from an IRA like a savings account with your bank.
So now you may be wondering: what is the difference between a Traditional IRA and a ROTH IRA?
I’ll give you a hint: It’s all about taxes.
Traditional IRA
A Traditional IRA allows you to make tax-deductible contributions (deposits) to the plan every year. What this means is that if you earned $60,000 for the year and contributed $6,000 to your Traditional IRA(s), then you would only be taxed that year on $54,000 of earned income. This is called a tax-deferred contribution. Now pay attention to the word “deferred” in the previous sentence. What this means is you are not just getting out of paying taxes on this contribution entirely. Rather, you are committing to paying taxes on it later, typically when you retire. When you reach the aforementioned retirement age of 59 1/2 years old, you may begin taking “qualified distributions” (or withdrawals) from the IRA, and at that time those distributions are taxed/become taxable income. This includes any profit or gains you realized from investing your tax-deferred contributions.
Now you may be asking: Well, what’s the benefit of that?
And I’ll tell you: It’s still all about taxes.
To Contribute or Not to Contribute
Typically, at the time of your contribution, you are earning income from a job or other source, and if you’re lucky, you’re in a higher tax bracket because of it (meaning you make enough money for the IRS to want a bigger piece of the pie). However, when you retire, you’re no longer working that job, meaning your tax bracket is then determined by how much you pay yourself in retirement, like from your IRA, for example. See where this is going? So when you retire, and are taking distributions from your Traditional IRA, if your distributions and other retirement income are less than your current income, then you would be paying lower taxes at that time than if you were to pay taxes now at your current tax rate. But again, keep in mind that any gains from investments made with your IRA will also be taxed when distributed. Alternatively, though, remember that if you made those same investments now outside your IRA (or another tax-deferred retirement plan), you would have to pay taxes on those gains anyway at your current tax rate, so what could be less taxes on gains at retirement still seems preferable. However, something to take into consideration is that tax rates may increase before you retire, which would affect the amount of taxes you pay, and there’s no way right now to know what those rates will be. This leads us to the benefits of a ROTH IRA.
ROTH IRA
Using a ROTH IRA can be especially powerful if done properly. With a ROTH IRA, unlike a Traditional IRA, contributions you make to the IRA are not tax-deferred. This means if we use the same example we used previously, a $6,000 contribution to your ROTH IRA from an earned income of $60,000 would still result in you having to pay taxes on the full $60,000 for that year. However, there is a trade-off that I am especially fond of. In exchange for paying taxes on those contributions now, any distribution from your ROTH IRA at retirement, including gains you made from investments, are tax-free. Yes, you read that right. Tax-free income. Meaning if you leverage a ROTH IRA in addition to a Traditional IRA, distributions made from the ROTH IRA will not count towards your taxable income at retirement and therefore not attribute to an increase in your tax bracket for any distributions you also make from your Traditional IRA. If this is getting somewhat confusing, I apologize. In summary, Traditional means paying taxes on contributions and gains later, instead of on just contributions now, like with a ROTH, and you don’t have to pay taxes on gains later. Now you may be thinking: Why didn’t you just start with that? Well, what would the fun be in that?
Withdrawals
Now it is important to note, that as mentioned earlier, the retirement age is currently 59 1/2 years old, and any unqualified distribution from a Traditional IRA before that time would result in both taxes and penalties. The same is true for a ROTH IRA, with one important exception: you can distribute/withdraw any contributions you made to a ROTH IRA at any point in time tax and penalty free (just not any gains/profits made). Don’t let anyone tell you differently. In fact, if you have a ROTH IRA with some money in it, and you need a once in a blue moon influx of cash, you have two options:
- You can perform a “rollover” to the same or different ROTH IRA and, if done manually (yourself), gives you 60 days to “move” the funds into the destination ROTH IRA, even if its where you withdrew the funds from. Now it’s not my place, or anyone else’s in my opinion, to tell you what you can do with that money in those 60 days, as long as the same amount of funds your withdrew go back into a ROTH IRA within 60 days. Pretty cool, right? However, you can only do this once in a rolling 365 day period.
- You can withdraw from a ROTH IRA up to your contribution amount, tax and penalty free, and call it a day. But keep in mind that re-contributing will count towards your annual contribution limit (if not using the above strategy). So if you withdraw some or all of your contributions, and recontributing the withdrawed amount would exceed your annual contribution limit, it may be difficult to catch back up to where your savings would have been. This can lead to a snowball effect and massive losses on what could have been exponential/compounding returns.
Tax and Penalty Exceptions
When withdrawing funds from an ROTH IRA using one of the above options, it is important that you remember to opt to not withhold taxes, and ensure that your brokerage is aware that you are entitled to make one of the 2 above distributions tax and penalty free. Otherwise, you will get out less than you asked for, and I may be just speaking for myself, but any time I have the option to withhold tax, I politely decline. The IRS can wait until I file my taxes to get my money.
As a bonus, if you qualify as a first-time home buyer, you can also withdraw up to $10,000 from your IRA to use as a down payment (or to help build/rebuild a home) without having to pay the 10% early withdrawal penalty! However, you’ll still have to pay regular income tax on the withdrawal if using a Traditional IRA. You just need to have opened your first IRA more than 5 years prior, unless only withdrawing contributions previously made to a ROTH IRA.
Required Minimum Distributions
Another consideration to make when deciding between whether to invest in your Traditional IRA or your ROTH IRA, is to determine when you anticipate withdrawing those savings. With a Traditional IRA, it is required that you start taking minimum distributions at the age of 72, and remember that the IRS taxes it as income. However, with a ROTH IRA, there currently is no such requirement, and in fact you can even leave your ROTH IRA to your children, tax-free (as long as you’ve had the IRA for at least 5 years).
Summary
The choice between Traditional and ROTH depends largely on where you are financially, where you see yourself at retirement (or where you desire to be), and, of course, expectations of tax rates at that time. A Traditional approach may be best to reduce your tax bill now, at the expense of being able to keep less of your retirement savings (due to taxes), whereas a ROTH strategy may be best to hedge yourself against rising tax rates and also protect your gains from taxation at retirement, plus the added benefit of using it somewhat like a savings account (withdrawing up to your contribution amount), so long as your contributions do not exceed your annual limit.
Both types can be (unofficially) used as emergency funds during a 60 day rollover (once every 365 days) tax and penalty free, or up to $10,000 used to invest in a home (although that amount is subject to income tax if pulling from a Traditional IRA). Leveraging both strategies can be beneficial with different kinds of investments, or expected returns. For example, I might use a Traditional IRA for safe investments with a relatively low expected rate of return, with the main benefit being the tax deduction, while I might use a ROTH IRA for more risky/high rate of return investments for the potential of tax-free retirement savings.
If you have any questions or comments, feel free to reach out to us at [email protected].