Roth vs Traditional IRA

Roth vs Traditional, the answer my shock you!

The answer is that there is now right answer. It is all circumstantial. The answer to this question would be very different for a person who is 18 years old earning minimum wage than for a 10 year career veteran making over 6 figures. If the answer was simple the question would be commonplace and we would not be here talking about it. 

What is an IRA?

An IRA is an Individual Investment Account. It is essentially a savings vehicle that allow you to invest your money in a variety of investments such as stocks, bond etfs, mutual funds and so on. The big benefit of an IRA is that it has tax incentives that amplify the impact of your savings. 

What are Tax Incentives? 

The first question that we need to address is what is income tax. Income tax is money that the government charges all income earning individuals in a country to fund all kinds of things (such as schools, roads $4M dollar public restrooms). Why are we even talking about this? Well the amount you pay in taxes directly affects the the potential size of your "Tax Incentive" we mentioned earlier (stick with me I'll bring all this together soon).

So how much am I paying in Income Tax?

Now the US government works in a progressive tax system. Meaning that the more you earn the more you pay in taxes. Looking at the tax bracket table next to us we see that an individual would pay $0 for the first $9,875 earned annually BUT the very next dollar ($9,875 + $1 = $9,876) would be charged 12% tax. In other words for every dollar over $9,875 you are paying Uncle Sam $0.12. The same happens over and over again until you reach you total annual pay. Meaning that someone who make $100k a year would pay nothing on the first $9,875. The she/he would pay 22% on the next $30,250 ($6,655 in taxes for this part) and so on until he/she reaches $100k. This mean that our friend making $100k a year would pay 32% on his/hers last $15,000 (or $4,800 ouch). 

What sort of tax incentives can I get from an IRA?

Glad you asked. There are essentially 2 types of tax incentives you can get from an IRA. This is were the whole Roth vs Traditional comes in. To make this easier let's talk about these two vehicles independently. 

What is a Traditional IRA

A traditional IRA allows you to contribute PRE-tax dollars. This means that you can subtract the amount you contributed to your traditional IRA from your annual income for tax purposes. Going back to our example of the person making $100k a year, if he/she were to contribute $5000 to a traditional IRA it would be as if his/her income was actually $95,000 for tax purposes. Meaning that  Angelina (I'm tiered of using pronouns) would save $1,600 in taxes for the year she made this contribution. That's about 800 tacos. So, whats the catch? You can't touch the money until you turn 59 and a half, unless you want to pay penalties (why not a whole number? Our government is full of geniuses). You are also on the hook when you do finally withdraw the money. This means that when you are 60 and you withdraw that money from your IRA Uncle Sam will sum up all your money from any income source (IRA, pay check, lottery, inheritance) and charge you per the income table above. You are essentially delaying when you pay your taxes. 

Of course there are a million things that could happen, such as the tax brackets changing or you not retiring with as much money as you originally thought you would (usually ending up with a lot less than you originally thought, unless you read my blog often).  Alright before we start talking about strategy or things to take into consideration let's talk about Roth.

What is a Roth IRA?

This is essentially the opposite of the traditional IRA. Instead of paying taxes on your money later you pay taxes on your money now or post-tax dollars. Using post-tax dollars to contribute to a Roth IRA mean that you no longer see that $1,600 tax deduction from investing $5,000 into a Roth IRA with a $100k income. So why would you do it? The answer is Tax Free Withdrawals. Now there are a few more complicated and edge case benefits to Roth IRA's but at the moment we will benefit on the big one. Those $5k dollars invested in your Roth IRA could easily turn into $19,348.42 growing at a 7% rate over 20 years. And you would pay $0 in taxes when you withdraw that money. One is still subject to restrictions such as penalties for early withdrawal like in the traditional IRA. 

Okay but what am I suppose to do?

It all comes down to the following question. Do you think you would pay more taxes now or later? If you are a teenager making minimum wage, chances are you will probably earn more money in the future. This means that you should probably pay the cheaper taxes now (Roth) and when you are in a higher tax bracket in the future withdraw the money tax free. What about the opposite? Let's say you are at the top of your career and you don't think you would ever earn more than you are earning now even after retirement (maybe a sign you did not save enough for retirement, but hey it happens) then you might want to skip out on paying taxes now and you might want to pay them later when you are in a lower tax bracket. 

Let me make a generalization here. If you don't have a good idea of what your earning potential is check out sites like glassdoor.com or payscale.com to see what you could hope to earn one day and take decision based on that. If you plan on being a doctor but you are currently in school waiting tables then you might want to pay your taxes now (Roth) since your taxes are cheaper rather then when you are earning $200k+ and paying 35% in taxes. This example holds true specially for those of us earning less than $9,875 a year since you are not paying any taxes on that money and putting it in a Roth account would mean you NEVER end up paying taxes on that money, which is pretty great. 

If you happen to be in a place in your life where you simply don't know what the future holds you can use the median American house hold income as a guideline (Currently at ~$63,179). If you are under it you might want to pay taxes on it now (Roth) if you are over it maybe take the tax break and go Traditional. 

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.