April 15th (well, actually April 18th) has come and gone this year with its tax filings, paperwork and wailing and gnashing of teeth. So before the 11th hour arrives next April, let’s get that IRA set up now. Lest you be overwhelmed, we’ll start here: an IRA is NOT a type of investment. It is a type of account which holds investments. Investments are things like cash, stocks, bond, precious metals, your house, and your 1963 Corvette. And no, you can’t (typically) put the house or the Corvette in an IRA. And no, the 2016 Corvette isn’t an investment, it’s a toy; neither your spouse nor I are buying any different story no matter how you spin it.
But I digress. Let me get back on point by addressing a question I often hear, “Which is better, a Traditional IRA or a Roth?”
Okay, semi-quickly, I’ll explain. There are basically two types of IRAs (Individual Retirement Accounts): the Traditional and the Roth. The many other retirement accounts, including the ones through an employer, behave in similar fashion to the two we will discuss today.
The answer as to which is better is, of course, “It depends.”
Now try not to let your eyes glaze over and your interest wane, but here is the basic difference between the two. With the Traditional IRA, you pay zero taxes when you earn the money and make a deposit into the IRA account. When you withdraw the money during retirement, you pay regular income tax based upon the tax rates at that time.
With the Roth IRA account you earn your pay today, pay today’s income tax rate, and then make a deposit into your IRA account. When you withdraw your money in retirement, you pay zero taxes on what you take out no matter if it has grown to a zillion times what you put in.
Got it? Good. So now we can answer which is better. The (wrong) answer that jumps out at us is that the Roth is better because tax-free is always better than tax-deferred, right? No, no, no. The answer has to do with your tax rate, not when you pay the tax.
For example, if your tax rate is 20%, (ignoring all the dedications and so forth) you get to keep 80 cents of every dollar you earn. Mathematically stated, your NET INCOME = 80% x GROSS INCOME. If you invest in a Traditional IRA you end up in retirement with:
(GROSS INCOME x YEAR 1 EARNINGS x YEAR 2 EARNINGS x … x YEAR n EARINGS) x 80%
If you invest in a Roth IRA you end up in retirement with:
80% x (GROSS INCOME x YEAR 1 EARNINGS x YEAR 2 EARNINGS x … x YEAR n EARINGS)
It comes out the same, if the tax rate is the same in retirement as it is now. The key to figuring out which is better for you, is to estimate when your income rate will be higher. If your tax rate is higher now than in retirement you want the Traditional IRA. If the opposite is true, the Roth serves you better.
Should you be in a position to be generous with what you have, give thought to whom you give and also how you give. Any gift to a charity should be given proper consideration as to how that gift is completed.
Let’s look at charitable giving. You know you want to give, but where will your gift have the most impact. First I suggest you look at what is truly of interest to you. What issues have influenced you? Health, education and the arts are some suggestions. Once you zero in on an area you want to have an impact on, do some homework. Not all non-profits are good stewards of money. Check out potential benefactors on web sites like Charity Navigator (http://www.charitynavigator.org/) and Guidstar (http://www.guidstar.org/) These can give guidance as to how much of your gift goes to administrative and how goes to the cause.
Once you are satisfied with the organizations credentials, examine how you want give. Cash may not be the best option. Perhaps you have a significant amount of stock that has greatly appreciated over the years. Especially in the case where the stock represents a high concentration in your portfolio, a gift of stock may be the better gift than cash. Let’s say you want to gift $20,000 to a charity. Instead of cash, you give $20,000 in stock. Now assume your cost basis in that stock is $10,000. If you sold the stock to make your gift, you would pay taxes on the $10,000 capital gain. In the case where the same value in stock is donated, you don’t pay the capital gain and still get the full value deduction. Many nonprofits can facilitate this type of gift.