IRA Basics | April 2016
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.