﻿An Individual Retirement Account, the IRA is one of the most common retirement savings accounts
outside the employer sponsored 401k. In the United States, anyone with earned income can
open and contribute to an IRA. However, there is one important decision you need to make before
contributing to one. To invest in a Roth IRA or a Traditional IRA? Hi, if you are new to the
channel, my name is Tae from Financial Tortoise. Where we learn to grow our wealth, slow and
steady. Today we are going to deep dive into Roth and Traditional IRA. Understand what they are and
most importantly, determine which one might be the best retirement account for you. But first, let’s
understand what Individual Retirement Accounts are in the first place. As mentioned earlier,
anyone with earned income can open and contribute to an IRA. And a quick note here, earned income
here has to meet the IRA definition. Income from interest and dividends, Social Security benefits,
or child support does not count. However if you have earned income like wages,
salaries, commissions, tips, bonuses, or net income from self-employment you qualify to
contribute. The one major limitation is on the combined total that you can contribute to your
retirement accounts in a single year. We’ll cover that contribution limit later in the video. Also,
an IRA must be opened with an institution that has received Internal Revenue Service (IRS) approval
to offer these accounts. Choices include banks, brokerage companies, federally insured credit
unions, and savings and loan associations. And when you open an IRA, you can choose to invest
in a wide range of financial products. Such as stocks, bonds, exchange traded funds (ETFs), and
mutual funds. There are even self-directed IRAs that permit investors to make all the decisions
and give them access to a broader selection of investments, including real estate and
commodities. There are also several kinds of IRAs, on top of traditional and Roth IRAs, there are SEP
IRAs, and SIMPLE IRAs. Each has different rules regarding eligibility, taxation, and withdrawals.
In this video we will talk only about the two most common ones. The Traditional IRA and the Roth
IRA. Also because IRAs are meant for retirement savings, there is usually an early withdrawal
penalty of 10% if you take money out before age 59½. There are some notable exceptions—withdrawals
for educational expenses, for example, and for first-time home purchases, among others. Alright,
let's now deep dive into the difference between a Roth IRA and Traditional IRA, starting with
the Traditional IRA. The main difference between a Roth IRA and a traditional IRA is how and when you
get a tax break. Contributions to traditional IRAs are tax-deductible, but withdrawals in retirement
are taxable. To give you an example, let’s say you put $4,000 into an IRA. Your taxable
income for the year decreases by that amount. If your original taxable income was $100,000,
it is now $96,000. However, when you withdraw the money in retirement, both the initial investment
and the gains it earned are taxed at your income tax rate in the year you withdraw it. In essence,
your money grows on a tax-deferred basis in a traditional IRA. If you don't have
a retirement plan at work, your traditional IRA contributions are fully deductible. But
if you or your spouse have a retirement plan at work, such as a 401(k) or 403(b), your modified
adjusted gross income (MAGI) determines whether and how much of your traditional IRA contributions
can be deducted. I want to note that this doesn’t mean you can’t contribute to a Traditional IRA
if you are outside the modified adjusted gross income. It just means that you won’t receive the
benefit of tax deduction. For example, for 2022, if you are single or file as head of household and
have a retirement plan at work, your traditional IRA contributions are fully deductible if your
MAGI is below $68,000. If you are married filing jointly, your MAGI must be less than $109,000.
From there, you begin to lose deductions as your MAGI increases. We all have our unique situation
so I’ll have a link to the IRS website below in the description so you can understand where you
fall with your specific situation. Another thing to note regarding traditional IRA is what is
known as Required Minimum Distributions or RMDs. Starting at age 72, holders of traditional IRAs
must begin taking RMDs, which are based on account size and the person's life expectancy. Failure to
do so may result in a tax penalty equal to 50% of the amount of the required distribution. Alright,
let’s talk about the Roth IRA. In comparison to the Traditional IRA, contributions to Roth IRAs
are not tax-deductible, but the withdrawals in retirement are tax-free. You contribute to a Roth
IRA using after-tax dollars, but you do not have to pay any taxes on investment gains. When you
retire, you can withdraw from the account without incurring any income taxes on your withdrawals.
Contributions can also be withdrawn at any time without taxes or penalties. Given you’ve already
paid taxes on it when you contributed your money into a Roth IRA. In addition Roth IRAs also do
not have required minimum distributions (RMDs). If you don't need the money, you don't have to take
it out of your account. You can still contribute to a Roth IRA as long as you have eligible earned
income, no matter how old you are. An important fact to note regarding Roth IRA is that there are
income limitations for contributing to a Roth IRA. The phaseout range for single filers is
between $129,000 and $144,000 in 2022. For married couples filing joint taxes, the phase-out range is
between $204,000 to $214,000 in 2022. There is a contribution limit for both the Traditional
and the Roth IRA. For the year 2022, the annual individual contributions to IRAs cannot exceed
$6,000. If you are 50 or older, you can contribute up to $7,000 per year (the extra $1,000 is
considered a catch-up contribution) Alright, now that we have a good understanding of the general
difference between a traditional IRA and a Roth IRA, let’s see how we can decide which one is best
for us. To start out, we want to ask ourselves a few questions. The first question being. Do
I think my tax rate will be higher or lower in the future? If we can answer that question
definitively, we can theoretically choose the type of IRA that will give us the biggest tax savings.
If I expect to be in a higher tax bracket in retirement, choose a Roth IRA and its delayed tax
benefit. If you expect lower rates in retirement, choose a traditional IRA and its upfront tax
advantage. Now if this seems like an ambiguous question because I’m so far away from retirement,
no worries. Let’s move onto the next question which is more straightforward. Which one am I
eligible for? As I mentioned earlier, there are IRS rules on IRA eligibility primarily determined
by our income. Our income determines if we are even eligible to contribute to a Roth IRA. And our
income determines how much of our contribution to a traditional IRA we can deduct from this year’s
taxes. Note that traditional IRA deductibility is restricted only if we or our spouse has access to
a workplace savings plan like a 401(k). I’ll have a link to the chart in the description below but
let’s take a look at a couple case scenarios where your eligibility may make the determination for
you. Scenario 1. Let’s say that you have earned income, but your employer doesn’t offer a 401(k).
This is actually not too uncommon. According to the Bureau of Labor Statistics, in 2020,
some 33% of private industry workers didn’t have access to an employer-sponsored retirement plan.
A lot of small businesses just can’t afford an employer sponsored retirement plan. And let’s say
that your income puts you in a high tax bracket and you are looking for ways to lower your taxable
income. In this case, a traditional IRA might be a good option. It lowers your taxable income and the
deductibility restriction doesn’t apply because you don’t have an employer sponsored retirement
plan. Let’s look at Scenario 2. Let’s say that you do have a 401(k) plan at your work and your income
is above the IRA deduction limit. But below the Roth IRA income limit. If you are married filing
jointly this would mean your income is higher than $129,000 but lower than $204,000. In this case,
you would want to contribute to a Roth IRA. You won’t receive the tax deduction of the
traditional IRA anyways, so it would be better to contribute to a Roth IRA in order to receive
the tax benefit in withdrawal down the line. One caveat here is that even if your combined income
is above the Roth IRA income limit, there is still a way to contribute. I have a detailed video about
the Backdoor Roth IRA you can check out here if you’d like to learn more. Alright, with that said,
let me share with you my personal preference. For me, I believe that for most people it's better to
go with a Roth versus a Traditional IRA. Let me share with you a few reasons why. First is that
if you already have a traditional 401(k), Roth IRA provides additional tax diversification in
retirement. The classic 401(k) plan offered by most employers provides the same tax benefits as
a traditional IRA. Although some workplaces offer a Roth 401(k) option for employees,
if yours doesn’t, diverting some of those retirement savings dollars into a Roth IRA
will give you more options for managing your tax burden down the line. The second reason is
the fact that early withdrawal rules are much more flexible with a Roth IRA. Although early
withdrawals from retirement accounts are generally discouraged, if you do have to pull some money out
for unexpected emergencies, the Roth allows you to withdraw contributions at any time without having
to pay income taxes or an early withdrawal penalty. And to clarify, the contribution
is the initial money you put into the account. Not the earnings it made. On the other hand,
the IRS isn’t as lenient regarding dipping into a traditional IRA before retirement. We’ll likely
be hit with a hefty 10% early withdrawal penalty and owe taxes at our current income tax rate on
the money we take out. There are a few exceptions to this rule such as qualified higher education
expenses and first home purchase. But we’ll need to proceed much more carefully than we would with
a Roth. The third reason I like Roth IRA is that it has fewer restrictions in retirement.
Traditional IRAs require you to start taking required minimum distributions (RMDs) at age
72. The government gave its tax break early on and will eventually want its taxes. Roth IRA on
the other hand doesn’t have minimum distribution rules. If we don’t need the money, we are free
to let our investment stay put in the account to continue to grow tax-free as long as we live. With
the average life span nowadays around 80, imagine what 20 additional years of compounding can do to
our wealth. The key benefit of a traditional IRA for most people is the upfront tax break. And
I’m not dismissing this benefit. It can be a huge advantage for high earners who don’t have access
to a traditional 401k plan. But we will eventually have to face that tax burden in retirement.
We don’t know how the tax landscape can change in the future so I like the idea of having no tax
burden in my retirement if I could help it. Thank you guys for watching and if you like to learn
more about retirement plans in general, check out my video here. Until next time, all the best.