%20(500%20%C3%97%20150%20px)%20(600%20%C3%97%20150%20px).png)
What’s the difference between a Roth IRA and a Traditional IRA? Not only is there a difference between these two types of retirement accounts, the long term affects of either one can have an enormous impact.
Let’s step back a bit before we start. We all know what an IRA is right? If you said, “Individual Retirement Account”, you’d be wrong. IRA actually stands for “Individual Retirement Arrangement” (you can confirm it here).
Traditional IRA
The Traditional IRA dates back to 1974, when it was created by the Employee Retirement Income Security Act, or ERISA, as a way for taxpayers to be able to set aside a portion of their income for retirement to supplement their pensions. Back when it first came out the annual contribution limit was $1,500. Over the years those limits have steadily increased to the current 2019 limit of $6,000 (with an additional catch up of $1,000 for those over 50 years old).
So how does it work? Contributions to Traditional IRAs have specific restrictions based on income, tax filing status, as well as availability of other retirement plans; these are generally changing on an annual basis with eligibility requirements posted on the IRS website. The basic concept however, is that (eligible) contributions are deductible – that is, they reduce taxable income by the amount contributed.
For example, a $5,000 contribution to a Traditional IRA will result in a $5,000 reduction in taxable income for that tax year. What’s a tax year? Well, Traditional IRAs have an extended deadline for contributions of the previous year up until April 15th of the following year. That means you can decide to make that contribution this year while you’re doing your taxes and still receive the deduction for the year before.
What do I do with it before I retire? Traditional IRAs are meant to be held until the account owner is over 59 ½ years old, so one of the greatest benefits while you wait is the concept of compounding. While money is inside of an IRA, any kind of increase in value of the amount that is started with, whether it’s interest income, capital gains, or dividends, is not taxed in the year it occurs. Instead all taxation of growth in the account is deferred until the money is taken out, allowing all of the growth to be reinvested instead of used to pay taxes each year. Keep in mind there are some very specific situations where Traditional IRAs (and Roth IRAs) do in fact need to pay taxes on certain activities such as UBTI (Unrelated Business Taxable Income) on specialized investments within the IRA – this usually happens with some Private Equity investments and other investment structures and is not the case for most people.
What about when you take it out? That’s when it gets a little sticky. Along with having strict rules for getting the money in, there are also some steep penalties for taking the money out especially if it happens before “retirement age” of the account owner at 59 ½ years old. Penalties for early withdrawal are a straight 10% of the withdrawn amount, plus income taxes of the withdrawn amount. Depending on the dollar amount withdrawn and the account owner’s effective tax rate, the impact can be considerable. Keep in mind there can be a number of fees, surrender charges, and other expenses assessed depending on the specific type of investment vehicle that particular IRA is in, which is outside the scope of this discussion.
Traditional IRA Early Withdrawal, Example 1:
$10,000 withdrawn
Effective tax rate 15%
Penalty: 10% of $10,000 = $1,000
Taxes: 15% of $10,000 = $1,500
Total Penalties & Taxes: $1,000 + $1,500 = $2,500
Net usable proceeds from Traditional IRA: $10,000 - $2,500 = $7,500 (75% of withdrawn amount)
Traditional IRA Early Withdrawal, Example 2:
$100,000 withdrawn
Effective tax rate 32%
Penalty: 10% of $100,000 = $10,000
Taxes: 32% of $100,000 = $32,000
Total Penalties & Taxes: $10,000 + $32,000 = $42,000
Net usable proceeds from Traditional IRA: $100,000 - $42,000 = $58,000 (58% of withdrawn amount)
Traditional IRA REGULAR Withdrawal (after reaching age 59 ½), Example:
$100,000 withdrawn
Effective tax rate 15%
Penalty: 0%
Taxes: 15% of $100,000 = $15,000
Total Taxes: $15,000 = $15,000
Net usable proceeds from Traditional IRA: $100,000 - $15,000 = $85,000 (85% of withdrawn amount)
It’s very important to remember that although there will no longer be any penalties after age 59 ½, you’ll still have to pay taxes on the account. All of it. The IRS starts to require an account owner to do what’s called a Required Minimum Distribution, or RMD, once age 70 ½ is reached. This amount is approximately 3-4% of the previous year-end balance of all Traditional IRA (and other deferred retirement accounts) combined. There’s a special calculation to determine the actual RMD, based on age.
The penalty for not doing this is worse than those early withdrawals: 50% general excise tax on the RMD amount required. For example, if your RMD is $20,000 this year (4% of a $500,000 Traditional IRA balance), the tax penalty for not taking your RMD will be $10,000. Even if you’re not able to spend it all in your lifetime, your heirs will be required to pay the remaining taxes due on what’s left over in the account.
So how does the Traditional IRA sound so far? Complicated? Expensive? While the Traditional IRA has its benefits and can be the plan of choice for some, the Roth IRA can be ideal for most.
Roth IRA
Originally called the “IRA Plus” back in 1989 by senators Bob Packwood and William Roth, the proposed plan would allow individuals to invest up to $2,000 with no deductions, but could could be withdrawn tax-free at retirement. The Roth IRA was later established by the Taxpayer Relief Act of 1997 and over the years those limits have steadily increased to the current 2019 limit of $6,000 as well (with an additional catch up of $1,000 for those over 50 years old).
So how does it work? Contributions to Roth IRAs also have specific restrictions similar to the Traditional IRA with eligibility requirements posted on the IRS website. The basic concept however, is that (eligible) contributions are NOT deductible – that is, they do not reduce taxable income by the amount contributed.
For example, a $5,000 contribution to a Roth IRA will not result in any reduction in taxable income for that tax year. Roth IRAs also have an extended deadline for contributions of the previous year up until April 15th of the following year. That means you can decide to make that contribution this year while you’re doing your taxes and still contribute for the year before.
So what are the differences? Roth IRAs are not taxed on interest, capital gains, or dividends as long as the account has been opened for at least 5 years and the owner is over 59 ½ years old when the money is withdrawn. The contributed amount into a Roth IRA is also never penalized (since taxes have already been paid on those contributions). There are no RMDs either, so the account can be essentially held as long as you or your heirs want to, without being forced to withdraw any specified amount. This means that Roth IRAs can be transferred to trusts without income taxes at death, which can be used as an extremely effective estate and legacy planning tool.
Roth IRA REGULAR Withdrawal (after reaching age 59 ½), Example:
$100,000 withdrawn
Effective tax rate 15%
Penalty: 0%
Taxes: 0% of $100,000 = $0
Total Taxes: $0
Net usable proceeds from Roth IRA: $100,000 (100% of withdrawn amount)
There are also some nifty ways to get money into Roth IRAs, one of those ways is called the “Roth conversion”. Keep in mind there are also some other advanced techniques named the “Backdoor Roth IRA” as well as the “Mega Backdoor Roth”, both of which will be covered in future articles on this website.
What are Roth conversions? Many individuals who have done some sort of planning to save into some sort of tax-deferred retirement plan, whether into a 401(k), Traditional IRA, or another type of IRA (SIMPLE, SEP, etc), are able to convert a portion into a Roth IRA. The catch is, income taxes on the amount converted would have to be paid in the year it is converted – also the Tax Reform of 2018 eliminated the previous ability to recharacterize Roth conversions, making any conversions permanent, so be careful with estimating taxes!
The concept of conversions can be better understood by these two basic examples:
Example 1: $1,000,000 Traditional IRA balance
Effective tax rate at retirement: 25%
Amount owed to the IRS: 25% of $1,000,000 = $250,000
How much of that balance is actually “yours”: $1,000,000 - $250,000 = $750,000
Example 2: $1,000,000 Roth IRA balance
Effective tax rate at retirement: 25%
Amount owed to the IRS: 0% of $1,000,000 = $0
How much of that balance is actually “yours”: $1,000,000
It’s important to remember that these two examples assume that the balances are taken out all at once. Also the specific tax affects on the cumulative tax deductions from Traditional IRA contributions, as well as the potential tax impacts of Roth conversions are not illustrated – simply because each individual with have their own specific tax situation, which may change year after year.
So, which one is better? One of the worst things to hear from any professional is the two words, “it depends”. Unfortunately, it does depend on a large number of different factors. One thing to remember is to never copy the strategy a co-worker, friend, or family member does – since everyone’s situation is different, even if it seems on the outside to be exactly the same. Always consult with a qualified tax professional before making any changes on your own retirement plan.
Ready to get started?
Once you decide on whether a Traditional IRA or Roth IRA account is best for you, finding the right kind of company to invest with can be a challenge. There are literally tens of thousands of different stocks, bonds, mutual funds, and other investments to choose from. Some people choose to use a financial advisor to help them decide; however, most financial advisors don’t actually manage a client’s account and instead sell annuities and/or mutual funds that charge commissions, either up front or later on when the money is withdrawn. These products can be very complicated as well as incredibly expensive.
If you have a portfolio of $500,000 or more, contact us to learn more about our exclusive specialty portfolios focused on equities, real estate, and commodities. Our management fees are institutionally priced and we never charge commissions for any investment. Our portfolios are directly managed, using proprietary analytics to determine the ideal mix and investment holdings.
