Many people have heard about Roth IRA’s and wonder, what’s the difference and should I pay attention to them? The answer is yes, and we’ll explain why in layman’s terms. There are rules, tax benefits, and limits and we can break them down to get a sense of what might be beneficial for your individual situation.
Who and What is a Roth?
As a Jeopardy answer, the Roth IRA (Individual Retirement Account) is named after former U.S. Senator William Roth, Jr., who sponsored the Tax Relief Act of 1997 which created the Roth IRA. Why is that important? It’s important is because the most significant difference between Traditional and Roth IRA is the tax treatment. That may not sound all that sexy and interesting, but it could mean tens of thousands of dollars in the long run and that’s why we need to start paying attention.
Disclaimer: Before we dive into discussions about IRA’s, make sure you are maximizing your employer match on your 401k, before funding an IRA, if that is available to you. Check out our free guide on Conquering your 401k. Don’t pass up a dollar-for-dollar match on your investments. IRA’s are for additional investing after the match.
With that said, let’s talk about what an IRA is and then we’ll compare and contrast the Traditional and Roth IRA.
An Individual Retirement Account (IRA) is an investment account for the purposes of retirement that is completely under your control. Unlike your 401k, with an IRA, there are few restrictions on your investment options and it is not tied to an employer. The two major types of IRA’s are the Traditional IRA and the Roth. Again, the major difference in the two is the tax treatment and it’s an important distinction.
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The major difference between the Traditional and Roth IRA is when you pay taxes and what you pay taxes on. As you can see from the chart above, with a Traditional IRA you contribute pre-tax dollars, meaning you can deduct contributions from your federal taxes and lower your taxable income. In a Traditional IRA, the taxes you didn’t pay on those contributions are postponed (deferred) until you withdraw. On the other hand, with a Roth IRA, you fund the account with your income after paying income taxes. In other words, there’s no tax break today, but you won’t have a tax bill when you retire and that full account balance is yours.
We don’t know what tax rates will be in the future, so it is a bit of a gamble. If you believe your taxes will be lower when you retire, than a traditional IRA may be your best option. However, if you’re under age 40 and have 20+ years until retirement, the second line of the chart is what should catch your attention.
The whole idea of saving for retirement is investing dollars today so it can grow much faster than inflation and have adequate savings to stop working. You want your contributions to multiply over a number of years. If that’s the case, in a Roth IRA investment earnings grow tax-free.
Roth IRA simplified example – Jane Doe contributes and invests one time $5000 (after-tax dollars) in a Roth IRA at in 2010. When she retires in 2045 (after age 59 ½), that contribution and the investment earnings are now worth $20,000. She can withdraw all $20,000 with no additional taxes.
Traditional IRA simplified example – Jane Doe contributes and invests one time $5,000 (pre-tax dollars) in a Traditional IRA in 2010. She receives a tax break in 2010. When she retires in 2045 (after age 59 ½), that contribution and the investment earnings are now worth $20,000. When she goes to withdraw the $20,000, she will have to pay income taxes on all $20K (not just the $5K contribution) at her 2045 income tax rate.
Moral of the story: The advantage of the Roth is not paying taxes on the $15K of investment earnings.
As always with taxes and the IRS, it’s never simple. There are additional details that you need to be aware of in terms of contribution limits and income limits that apply to be eligible.
In general, the IRA contribution limit is $5,500 in 2016 and 2017 ($6,500 for age 50+), but you have until tax day the following year to contribute for that tax year. So in this case, you’ll have until April 18, 2017, to contribute for the 2016 tax year.
There are also income limits, which, depending on your tax filing status can mean either you can contribute less than the max or none at all. For single filers, the limit begins reducing at a Modified Adjusted Gross Income (AGI) of $117K and married filing jointly at $184K. These may change in the future so be sure to check with a tax professional or the IRS Website to get more details.
So again, if you’ve eliminated high-interest credit card debt, maximized your employer match and looking for a tax-advantaged investment vehicle, a Roth IRA is a great option.