Traditional vs Roth IRA: Why You Need One Now!

I was recently asked, "What should be my first step towards investing?" My first response was, "You need an IRA." It is no surprise to me that most people in their early twenties have never heard about IRAs, but it is one of the most successful vehicles for financial achievement. In this blog post, I will be going over what an IRA is, why you need one, and the difference between Traditional and Roth IRAs.

What is an IRA?

IRA stands for Individual Retirement Account. This type of account is exactly what it sounds like, an investment tool used to save for retirement. One who uses an IRA first has to deposit money into an IRA account. Once accomplished, they can begin investing their money into assets such as stocks, bonds, mutual funds, annuities, ETFs ,and even real estate. Ideally, you would invest your money by buying one of these assets and returning a percentage of your investment as profit. Instead of simply saving cash for retirement, an IRA allows your money to make more money.

Why do I need an IRA?

You may think that retirement is a long ways away and taking money that you need currently and putting it in an IRA is a waste. However, my response to that is... consider compound interest. Time is an exponential factor when it comes to making a lot of money. The best way to show this is with an example. If a 20 year old decides to start investing into an IRA with $2,000 and each year invested an additional $2,000 dollars until the retirement age of 60. Assuming his average return on investment was 10%, this wise 20 year old would acquire an account value of $1,064,222. The total amount of contributions he personally made would be $80,000. You read that right, $982,222 worth of pure profit from his investments. Now lets say you wait until the age of 40 to start investing with an initial investment of $2,000 dollars. You would have to contribute $16,678 a year in order to have $1,064,222 by the age of 60. Your total personal contributions would amount to $333,563.and total profit from investments would be $728,658. Having an additional $14,678 of disposable income from age 40 to age 60 allows you a lot of financial freedom and you do not have to stress about being able to afford retirement.

Another benefit of having an IRA is the tax breaks that they utilize. It goes back to the saying, "a dollar saved is a dollar earned." Money that stays in your pocket is money you can utilize to better serve you. We will delve deeper into types of IRA and the tax implications that come with each of them.

Difference Between Roth and Traditional IRA

The main difference between a Roth and Traditional IRA is when you are taxed. Compared to a Traditional Brokerage Account (another type of account that you can invest in) IRAs have a much better tax advantage. In a Traditional Brokerage account, you use your already taxed income to invest and then pay 10-20% tax rate on any profit you make. With an IRA you are taxed much less. In a Traditional IRA, any money you contribute to the account is tax deferred. This simply means that if you are making $50,000 a year and contribute $5,000 to your IRA, instead of having to pay income tax on the $50,000 you will only have to pay income tax on $45,000. In doing so, you are saving close to $1,000 dollars a year! However, with a Traditional IRA, the money you pull out of it each year in retirement faces income tax. If you plan to only pull out small amounts of money in retirement, this would be the right plan to use because your value will grow much quicker and you will not incur a very high income tax. What should you do if you plan on pulling out large sums of money in retirement and want to avoid a hefty income tax? You should invest in a Roth IRA!

A user of a Roth IRA will deposit money that has already been taxed. For example, if you make $50,000 a year and want to invest $5,000 into your Roth IRA your entire $50,000 will still face an income tax. However, the amazing upside to the Roth IRA is that all profits are tax free after the age of 59.5. If the 20 year old from the example earlier decided to pull their entire $1,064,222 out of their Roth IRA they would get to keep 100% percent of that money. However, if they invested in a Traditional IRA that $1,064,222 would be hit with an income tax of roughly 37%. Of course that number depends on the tax code at the time of withdrawal. This means roughly $390,000 would be lost to taxes. So it is wise to keep this in mind when choosing what account to invest with.

Should I Use Roth or Traditional?

Whether you invest in a Roth IRA or a Traditional IRA really depends on you. If you plan to pull out large sums of money at a time in retirement I would highly suggest using a Roth account, but if you just need to pull out 20,000 dollars a year because you have a pension or 401k you are withdrawing from then a Traditional IRA may suit your needs. Generally, when you are young and first start working your tax rate isn't very high so it may be wise to start with a Roth IRA and as you get older and your income increases it may be better to invest more heavy into a Traditional IRA. I personally invest in both with the idea that I can pull out $22,000 from the Traditional IRA each year and stay within the smallest tax bracket of 10% and any additional expenses that I would need I can take a tax free withdrawal from the Roth IRA. One thing to keep in mind is that the future is unknown and the tax brackets are always changing. The tax rates could potentially be much higher by the time you want to retire or possibly lower than they are now. However, if you have investments in both forms of accounts it just gives you added flexibility.

Pros and Cons of an IRA

Cons: One major con of an IRA is that you have to wait until you are at least 59.5 years old to withdraw the money from the account. Since this is a retirement account there is stipulations that encourage the user to only use the money in retirement. If you run into a financial emergency and must pull money out of your IRA, you can, however, there will be a 10% deduction to the money that you withdraw early. So you should only do this in times of emergencies. Another con of the IRA is the contribution limit. You can only contribute $6,500 in total to IRA accounts. This is just another reason you should invest in the IRAs early. One final con to an IRA that gets overlooked by many is the chance that you do not live long enough to utilize your retirement plan. As morbid as it sounds, living to be 59.5 years old is not a guarantee, but it is still important to plan ahead and be prepared if you do. I will cover other means of making money that you can utilize at a younger age in later blog posts, but IRAs are very important to consider at a young age.

Pros: The tax benefits that come with an IRA are great for keeping as much of your income in your pocket as possible. The 10% early withdrawal penalty can be avoided for special cases such as buying your first home or paying for you or a child's higher education. Another great aspect of an IRA is that it helps build generational wealth. You can assign your children as beneficiaries of your IRA and they will inherit your wealth. If it is a Roth IRA they will inherit most of the money tax free.

Conclusion

In conclusion, if you are looking to begin investing, look into opening either a Traditional or Roth IRA, or both. The younger you are when you begin investing for retirement the more prepared you will be when the time comes. It is how most millionaires are made in today's world and it is how you build generational wealth. If you have any questions, comments, or concerns feel free to leave a comment on this post. I highly recommend the books that are posted at the bottom of this blog as they will help you maximize the profits made in your IRAs and give you insanely helpful financial advice.

A Random Walk Down Wall Street by Burton G. Malkiel : This book will teach you how to invest and the importance of investing. It will also break down what you should be investing in based on your age group.

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The Intelligent Investor by Benjamin Graham: Billy Graham is known as the father of investing. He wrote the Intelligent Investor in 1949 and his tips and theories in the market has stood the test of time. This is a must have if you wish to learn about the stock market.

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Products posted are amazon affiliated products.

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