In 1997, William Roth, the late senator from Delaware signed the Roth IRA into being, but why go to all the effort of creating a new type of retirement account?
Let's compare the Roth IRA to a traditional IRA.
First, there are some similarities between a traditional and a Roth IRA, namely that they’re bound by the same contribution limit. As of 2015, you can put up to $5,500 into either your traditional or your Roth IRA, as long as you’re under 50. If you’re over 50, you can put up to $6,500 a year into either your traditional or Roth IRA.
It’s worth noting that there are some loopholes to this that will allow you to either contribute more money into your IRA or will allow you to move money from your traditional to your Roth IRA. If that’s something you’re considering, you should speak to an investment advisor.
Second, for either a traditional or a Roth IRA, the earnings on the money inside of the account aren’t taxed. This means that if you hold a bond in the IRA that pays interest, you won’t be taxed on the interest payments you receive in that account. This often means that an IRA investment account may benefit from holding different securities than a taxable account, but that’s outside the scope of this article.
As for key differences, when you turn 70, a traditional IRA will force you to make withdrawals from your account, it's called the 'required minimum distribution' or RMD for short. However, a Roth IRA won't force you to take a distribution and this can result in some useful strategies for transferring money to your heirs.
The biggest difference though is that the money you put into a traditional IRA is tax deferred. This means that if you put $5,000 into your regular IRA, you won’t pay taxes on that money. However, if it was a Roth IRA, you would pay taxes on that $5,000 because a Roth IRA isn’t tax deferred.
That might not sound so great, but the big advantage of a Roth IRA is that the withdrawals are tax-free!
As an example, if you are over 59 and 1/2 years old and are doing a withdrawal from your traditional IRA account, you’ll be taxed on that money at the ordinary income tax rate. [This is what ‘tax-deferred’ means because you haven’t eliminated the taxes on that money, but you may have delayed it by a couple decades.] While in the Roth IRA, you pay no taxes on that withdrawal.
The big advantage of this is that you pay taxes on the smaller amount of money that you put into your Roth IRA, and not on the larger total it grows to over a few decades, - that will be tax-free when you withdraw it.
Lastly, for a traditional IRA, any amount taken out before retirement age is subject to a 10% penalty fee plus you have to pay taxes on the withdrawal, but for a Roth IRA, you don’t pay taxes on your withdrawal - as long as it’s only part of the principal that you originally put in. Additionally, there are some exceptions that let you withdraw money from your Roth IRA for a first-home purchase or college expenses (as of 2015), but generally, this is not recommended because there are usually better ways to finance those expenses than from your Roth IRA.
So, let’s look at some numbers.
Let's go step-by-step and see how the economics change whether you're using a traditional or a Roth IRA.
Traditional IRA
- Start with $5,000
- Won't pay any taxes on the contribution, just on the withdrawal
- Principal of $5,000 goes into the traditional IRA
- Invest it!
- Let's say you invest it for 5 years in the stock market and it doubles. So that $5,000 is now worth $10,000.
- Hypothetically, if you needed $3,400 for an emergency and you're not 59 and 1/2 years old, you'll have to do two things. First, you'll have to pay taxes (let's assume 32% tax bracket again) of about $1,088. Second, you'll have to pay a penalty of 10% or $340. That'll leave you with $1,972 toward your emergency.
- Now, let's assume you never took any money out, and go all the way to retirement and your investment has doubled again and is now worth $20,000 and you're at a 25% tax bracket, as you're no longer working.
- If you were to withdraw all $20,000, you'd pay $5,00 in taxes and would be left with $15,000 for retirement.
Roth IRA
- Start with $5,000
- Assuming a 32% tax bracket, you'll pay $1,600 in taxes on the contribution.
- The remaining $3,400 is the principal that goes into the Roth IRA.
- Invest it!
- Let's say you invest it for 5 years in the stock market and it doubles. So that $3,400 is now worth $6,800.
- Hypothetically, if you needed $3,400 for an emergency and you're not 59 and 1/2 years old, you can withdraw that without taxes or penalties because you put in $3,400 in principal at the beginning. However, if you needed more than that, you'd have to pay penalties and taxes on the excess just like a traditional IRA.
- Now, let's assume you never took any money out, and go all the way to retirement and your investment has doubled again and is now worth $13,600 and you're at a 25% tax bracket, as you're no longer working.
- If you were to withdraw all $13,600, you would pay no taxes on it so your tax bracket doesn't matter, and you would just get all $13,600 in the account - but still $1,400 less than a traditional IRA!
So IS A ROTH IRA INFERIOR TO A TRADITIONAL IRA?
In many cases, yes - a Roth IRA won't perform as well as a traditional IRA. Here's a study by the Clute Institute on the circumstances where a Roth IRA does outperform a traditional IRA.
However, a Roth IRA will generally outperform a traditional IRA if either: i) your tax rate right now is currently very low, or ii) your tax rate at retirement is very high.
And while the end results for a Roth IRA or a traditional IRA may be quite similar, it's important to remember that a Roth IRA has some additional flexibility, and that depending on your circumstances, may be a great option for you. If you have additional questions, feel free to reach out to an advisor to see if a Roth IRA is a good option for you.
