If you are like me, then you really don’t enjoying being part of a conversation and not have a clue on the subject matter. This is especially true when it comes to financial topics. A few years back, I was with some friends and the topic of IRA’s somehow came about…I was lost in translation. However, that of lack of knowledge and insight towards that subject peeked my interest to the point where today I’m a licensed Investment Professional. Let’s dive in!
Traditional IRA
First, what’s an IRA? IRA is short for Individual Retirement Account. Traditional IRA’s where established in 1974 by the Employee Retirement Income Security Act (ERISA). The rational for IRA’s came about the realization that as cost of living increased along with the increased life span of retirees, Social Security simply wasn’t going to able to keep up. The need for individuals to fund their own retirements became and continues to be an increasing necessity.
Traditional IRA’s provide for tax-deferred growth of your contributions. Let’s say that last year you contributed $2400 into your traditional IRA. The a benefit of this $2400 contribution is it’s a tax deduction from your current tax liability. When its time to do your taxes, you can deduct the $2400 from your income. If you’re in the 24% tax bracket as most Americans are, you just made a 24% rate of return on your $2400. Nice!!
When it comes time to retire and you want to begin to taking distributions from your traditional IRA, the distributions are taxable. Remember, since the account grew tax-deferred and you claimed the contributions as a tax deduction along the way, at withdraw, the taxes are due. Uncle Sam needs his cut.
Roth IRA’s
Roth IRA’s where born out of the Tax Relief Act of 1997. The major significance of the Roth in comparison to the Traditional IRA is in how it’s taxed. Roth IRA’s contributions and growth can be withdraw tax free. Since the contribution is made with after tax dollars and is not a tax deduction at the time of contribution, the distribution is tax free. That can be a major advantage at retirement if your income level still places you in an upper tax bracket. Withdraw from your Roth would be considered a non-taxable event.
Commonalities for both Traditional & Roth
Since both the traditional and the Roth IRA’s are retirement accounts, withdraws prior to 59 1/2 years of age will incur a 10% early withdraw penalty on the distribution. With the ROTH, that’s the only penalty. With the traditional, the 10% penalty will be in addition to paying taxes on the distribution amount as ordinary income. There are specific circumstances where an early withdraw can avoid paying the 10% penalty. For those situations please consult your tax professional or visit IRS.gov.
Currently the contribution limits are the same for both traditional and Roth’s. If you are under the age of 50, you can contribute a maximum of $6000 per year into the account. Once you are older than 50, the IRS allows a catch-up provision of an additional $1000 for a total of $7000 per year. The contribution limits are set by the IRS.
Additional Differences
Traditional IRA’s have a Required Minimum Distribution (RMD) starting at age 72. The amount of your RMD is based on both your prior year’s account balance and an IRA table based on your age.* If you do not take the RMD, even if you don’t need the money, there is a 50% penalty on top of the RMD. Take the money, pay Uncle Sam his due and move on.
Roth IRA’s do not have an RMD. The money can stay in the account and continue to grow tax free.
Roth IRA’s do have maximum income restrictions for contributions in a given year. If you file taxes as a single person, the modified adjusted gross income is $139,000 for 2020. If you are married and file jointly, then the your modified adjusted gross income must be $206,000 for 2020. Anyone making above the single/married thresholds would have to use a traditional IRA.
In conclusion, IRA’s are an excellent vehicle for growing your net worth and working your way towards financial independence. With that said, IRA’s are just that, a vehicle. You can have Chevy or you can have a Bentley. How your IRA’s is invested is a completely different conversation. For specific insight into your own individual situation, please feel free to contact me at Louis@louisromero.com.
*Investopedia.com/roth-ira-required-minimum-distribution