Roth vs. Traditional IRA

Roth IRA vs. Traditional IRA

Roth vs. Traditional IRA

Grant Sabatier

Founder of Millennial Money. Dubbed "The Millennial Millionaire" by CNBC, Grant went from $2.26 to over $1 million in 5 years, reaching financial independence at age 30. He's passionate about helping others build wealth and is addicted to Personal Capital.

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Millennial Money Snapshot: You can put $5,500 each year into a Roth or Traditional individual retirement account (IRA). You can put money in a Roth IRA after you’ve paid taxes on it and then your money grows tax free. That’s a sweet deal and often best for Millennials. In a Traditional IRA you put money in before paying taxes on it and you can often deduct the contribution from your taxes if you don’t have a retirement plan at work or you make less than $71,000 a year. If you make under $125,000 invest in a Roth IRA, but if you make over $125,000 then invest in a Traditional IRA and then you can convert it to a Roth IRA. It is important to remember IRAs are retirement vehicles that hold investments so you have to pick what goes inside them – often mutual funds or ETFs that track different segments of the stock and bond markets.

Retirement not a guarantee for Millennials

It is no secret that Millennials are going to have a hard time retiring due to low wages and with massive student debt that are prohibiting us from saving as much money as we will need. Just one generation ago employees would be protected with the pensions they earned from years of working at the same company – a prize for their loyalty and hard work. That was from a time when companies were willing to bet on their employees for life.

My own father has a pension that he will be able to take when he retires (in the next few years) and he will get paid between 50-60% of his full-time salary for the rest of his life. When it comes to retirement security it doesn’t get more bullet-proof than that. Pensions were awesome, but most are gone and we have been left to save for ourselves and know. Unfortunately saving for retirement is tough, but if you don’t save as much as you can now retirement might not be possible and it certainly isn’t guaranteed.

But most Millennials have started saving

According to recent research on Millennials, 71% of Millennials today are participating in a 401k account if one is available to them. This is great news and definitely an amazing first step, but what about if your company doesn’t offer a 401k or what do you do if you have already contributed the $17,500 maximum allowed contribution to your 401k and you still have more money to invest? In both of these situations you should then open up an IRA (independent retirement account) and try to save the $5,500 maximum the IRS allows you to put into it each year.

It is often best to first maximize your 401k savings before investing in an IRA, or at least make sure you invest enough to get your employer match contribution. After you have gotten your employer match it could make sense for you to open an IRA account to diversify your investments and have the opportunity to grow some of your money tax free in a Roth IRA. Here are the differences between a Roth IRA and a Traditional IRA.

Roth IRA vs. Traditional IRA

Let’s compare the differences and similarities between the Roth IRA and Traditional IRA and let them battle it out to see why a Roth IRA is often the best choice for Millennial investors.

Taxation:

Roth IRAs and Traditional IRAs both offer great tax benefits and minimizing the impact of taxes is essential to building wealth. Let’s see how they are different.

  • Roth IRAs are taxed before you put the money into your investment account and Traditional IRAs are taxed when you take the money out.
  • Traditional IRAs are tax deductible on both state and federal taxes the same year that you make your contribution if you make less than $71,000 you can take a deduction. But the Traditional IRA has certain restricts on when and how you can take a deduction. See what the IRS says here.
  • Financial advisors often recommend that you think about what your income should be in retirement (will it be higher or lower) when picking a Roth vs. Traditional IRA. If you think it will be higher then you should invest in a Roth IRA and if it will be lower than invest in a Traditional IRA. I think this is a bad way to decide (since who knows how much you will be taxed when you retire) and that a Roth in almost all cases will be better since your money and the profits grow tax free.

WINNER: Roth IRA – because your money grows tax free and you can take out all of the profits without paying taxes once you reach the age of 59.5.

 

Contributions:

Unfortunately the IRS don’t want to give you unlimited tax free investment opportunities so they cap the amount that you can contribute each year to your account. This has always seemed like pretty low amount to me and honestly like the IRS don’t want most people to retire – so they can continue to receive income tax when you need to work for the rest of your life. But IRAs, in addition to our 401ks, are the best option we have right now to take advantage of tax advantaged investing. Let’s look at some of the similarities and differences.

  • Both Roth IRA and Traditional IRAs have annual contribution limits of $5,500 (or $6,500 if you are over the age of 50)
  • Roth IRAs allow you to contribute funds at any point in your life
  • Traditional IRAs only allow contributions until the age of 70.5
  • Roth IRA requires that the first contribution be made at least five years prior to the beginning of qualified distribution. Traditional IRA has no such requirement.
  • You can contribute up until April 15th (tax day) of the following year for the prior years contribution. This means if you don’t have enough money to put into your IRA by Dec 31st you can still contribute until April 15th.

Keep in mind that your income may price you out of qualifying for a Roth IRA. In 2015 individual gross income cannot exceed $131,000 and $193,000 for married couples filing jointly. If your income is above the allotted maximum amount, you would have to defer to the Traditional IRA rather than a Roth IRA. Learn more about IRA contribution limits on the IRS website.

WINNER: Roth IRA – because you can contribute at any point in your life. It is even getting more common for parents to open a Roth IRA for their children and start making contributions.

 

Withdrawals:

So you have spent time saving up money in your IRA for years and are ready to start taking money out, or maybe you are ready to buy a house or lost your job and you need to tap into your account. What are the withdrawal restrictions?

  • Both Roth and Traditional IRAs have a minimum qualifying age of 59.5 when you can begin to make withdrawals of your contributions
  • Traditional IRA has a requirement that you need to start making withdrawals from your account by the age of 70.5
  • A Roth IRA does not have such a requirement and you can actually leave the money in them forever and transfer them over to someone else when you die (this makes them great wealth transfer vehicles). Note: Beneficiaries of a Roth IRA do not owe income tax on withdrawals and can extend their distributions over a long period of time.
  • Roth IRA has a 10% federal penalty tax on early withdrawals on earnings prior to the age of 59.5. It is important to note that the penalty is only on earnings and not your principal. You can take out the money you put in at anytime tax free, but try to keep it in as long as you can to let it grow!
  • Traditional IRA has a 10% federal penalty tax on both contributions and earnings
  • There are exceptions to the early withdrawal penalty – for example first time home-buyers are able to take out up to $10,000 from their Roth IRA to use towards the purchase of their first home.

WINNER: Roth IRA – because you can take out your principal anytime without a penalty and can make contributions at any age.

Conclusion

[box]Every Millennial should open and invest $5,500 per year in a Roth IRA[/box]

So it seems pretty clear that for most Millennials it makes the most sense to invest in a Roth IRA instead of a Traditional IRA if your income is under $131,000 per year. But what if your income is over $131,000 or what if you have already invested your money in a Traditional IRA and now realize that you should have put your money into a Roth IRA instead? Well thankfully there is a way to convert your Traditional IRA into a Roth IRA – which is what I do because my own income is over $131,000 per year. Converting a Traditional IRA to a Roth IRA is actually a pretty simple process, but please note that I am not a tax professional or accountant so I recommend that you consult with one before converting your IRA into a Roth. There can be a number of big tax consequences if you do this conversion incorrectly so I recommend you consult with a tax professional before doing this given your own unique situation. But here is how the conversion works.

How to Convert a Traditional IRA into a Roth IRA

This is what I do when converting my Traditional IRA into Roth IRA each year when I make contributions. First it is important to note that converting your Roth IRA into a Traditional IRA is what is known as a “taxable event” so you are required to pay taxes on the amount of profit/earnings that are in your Traditional IRA account. If you just put money into your Traditional IRA and converted it into a Roth IRA then you don’t owe any tax on the money (since there were no earnings on that money). But if you already have a Traditional IRA that has been growing and has increased in value then you would owe taxes on everything you convert into a Roth IRA.

This can get complicated and you can end up owing a lot of money to the IRS if your Traditional IRA has a lot of earnings – since you will be taxed on those earnings at your regular income tax level when you make the conversion to a Roth IRA. If you do have a lot of money already in your Traditional IRA and want to convert it then it is typically recommended that you wait until your income and tax levels are lower before making this conversion. But for me this doesn’t apply because I don’t have any money I keep in a Traditional IRA – so when I want to convert it just goes into my Traditional IRA (which is just a placeholder account) and then I immediately convert it into my Roth IRA and I don’t have to pay tax on it because there were no earning. Then my money can grow tax free in a Roth IRA and then I can take it out without having to pay taxes on it in the future.

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Grant Sabatier
grant@millennialmoney.com

Founder of Millennial Money. Dubbed “The Millennial Millionaire” by CNBC, Grant went from $2.26 to over $1 million in 5 years, reaching financial independence at age 30. He’s passionate about helping others build wealth and is addicted to Personal Capital.

2 Comments
  • John Sheprad
    Posted at 01:02h, 24 June Reply

    Thank you, I am 28…late to the investing scene. I literally just ordered the book you recommended in another post, the coffee house investor.

    I have over 20k in cash, thinking keeping it in the bank would do something magically. Finally woke up and I have a lot to learn, and although I am more than a little afraid I thank you.

    I’m reading a post or two from you every day.

    Do you have any other books you recommend?

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