Literally no one has ever asked me what the difference is between a Roth IRA and a Traditional IRA. I’m not great at the economics of supply and demand so I’m going to write an article about it. Understanding the difference between these two accounts is like eating broccoli. Only like three people in the continental United States like broccoli but it’s important to eat it for reasons nobody is sure about.
So, what is an IRA?
An IRA is an Individual Retirement Account. In 2017 you can contribute up to $5,500 into these accounts. You can split the money however you want as long as the total ads up to no more than $5,500.
What’s the difference between these two types of IRAs?
A Roth IRA is not tax-deductible so it’s funded with after tax money. This means you get taxed on your income like normal. You earn $60,000 the government taxes you on all $60,000 then you contribute the remaining money to your Roth IRA. The money grows tax-free and you are able to take the principle out tax and penalty free but you have to pay taxes and penalties for any of the earnings above and beyond the principle you take out before age 59 1/2.
There are some fun reasons why you might not be penalized for taking the earnings out before you turn 59 1/2 such as if you die. So if you really want to get that sweet, sweet IRA money tax and penalty free but you aren’t old enough you can always die. Silver lining.
A Traditional IRA is before tax so your contributions are tax deductible. If you earn $60,000 but contribute $5,500 to your Traditional IRA the government only gets to stick their hands in a pot of $54,500 (60,000-5,500) instead of the entire $60,000 which will save you a couple grand in taxes.
Pros of Traditional IRA: You can reach your limit faster. You only have to earn a gross of $5,500 to be able to max this account out whereas the Roth you probably have to earn closer to a gross of $9,166.67 which is then taxed at approximately 40% that then becomes $5,500 in after tax money that can go into your Roth. Follow? Follow. (God this is super boring. F-word me. I don’t even want to write this I don’t know how you’re still reading. Or, wait. Hello?)
Cons of Tradional IRA: The money will be taxed when you take it out after age 59 1/2 or you will be taxed and penalized if you take it out before age 59 1/2. (Unless you’re a sneaky S.O.B who does a Roth conversion ladder which we, mostly me, will talk about below.)
Pros of Roth IRA: That money is yours Holmes! Let that sweet, sweet nectar grow tax-free and take it out at a ripe old age or take the principle out at a less ripe old age. IDGAF what you do, it’s your money. (It’s not that easy, there are rules to these types of things.)
Cons of Roth IRA: Dumb name. Takes longer to max it out. Girls won’t respect you if you don’t max it out. Literally none of your friends will understand where the hell you put your money. Takes more money to max it out.
Which one is better? It depends what you want to do. If you plan on being a financially sound wizard who ends up retiring well before turning 59 1/2 you may want to give money to your Roth IRA because you can take that principle money out without a penalty…
But if you are really into the whole financial independence movement you may have heard of a Roth conversion ladder… (Made famous by Brandon at a blog which is much better than this blog called The MadFientist.) A Roth conversion ladder basically means you put money into a Traditional IRA then once you retire you convert a little bit each year from your Traditional IRA pot and move it into your Roth IRA pot. The money has to sit in the Roth IRA for at least 5 years before you can spend it so once you reach the sixth year of retirement you can start spending the money that you converted during your first year then in the seventh year you spend the money you converted during your second year of retirement and so forth. This effectively means you end up paying little to no taxes on it going in or going out! This is what we should all do. Side Note: If you haven’t read The MadFientist blog I don’t know why you’re reading this blog. If that blog was the Golden State Warriors this blog is the fat 11-year-old kid down the street who wears those trash talking Nike shirts that say things like “Dunk. All. Day” or some such thing. That blog is like an Imperial Stout fancy beer compared to the Kirkland Light which is this blog. That blog is like grass fortified with Scott’s turf builder, this blog is like that yard at the end of town that finally gets mowed after old man Lowery dies and it turns out there was a car underneath all that grass. I feel I’ve made my counter-productive point.
Wait, what? Great question. So, once you early retire your tax bracket will theoretically be way lower than it is during your working career (This isn’t necessarily true if you’re doing the standard work until you’re almost dead model but if you’re doing that you probably aren’t spending a lot of time reading blogs, or saving money #burn). When you convert money from Traditional IRA to Roth IRA you will be taxed on this money as income so you want to wait until you aren’t earning any other income (or as little as possible) so that you get taxed at a much lower bracket.
In 2017 for a married couple the tax rate is only 10% if you earn between $0 and $18,650 plus you get to add in the standard deduction of $12,700 which means you can earn up to $31,350 and still only be in the 10% tax bracket. Sweet, huh? If you accidentally have a couple kids, or whatever*, you get to add even more of a deduction.
*Not “or whatever” has to be actual dependents not like a cat or something.
Anyway, I hope that really clears up some confusion about IRAs and what type you should get. I’m not an accountant or even good at personal finance so for sure don’t take my advice without doing some more actual research.
Hugs and kisses,
-Dave
Fier Sprinkler 