If you start investing today, whenever you retire – be it 10, 20 or 40 years from now – you’ll have more money than if you start tomorrow. Better yet, both Traditional and Roth IRAs offer you some pretty sweet tax incentives to encourage you to save some coin. You know, for when you’re sipping drinks in Cabo, living the good life.
Key Points Comparing the Traditional IRA and the Roth IRA
Traditional and Roth IRAs differ in some crucial ways, but before I talk about that, I think I should tell you what features both of them share.
To invest in an IRA, you must have qualifying income to contribute. This is a fancy term for one of the following:
1) The salary/hourly wages you earn working as an employee
2) Self-employment income
3) Alimony income
Basically, if you have a job, you can contribute. Money you have socked away in a mattress, savings account or a regular old brokerage account cannot be put into an IRA. Pension, annuity and investment income cannot be used to contribute to your IRA. You may only contribute money that you have earned in the current calendar year. In addition, you can only contribute money that you’ve declared on your taxes.
In 2012, you’re allowed to contribute a maximum of $5,000 per year with a cut-off date of April 15. In 2013, this is set to jump to $5,500. For the gray-bearded: those over 50 may contribute an extra $1,000 ($6,000 total in 2012, $6500 in 2013).
It is very important to max out your yearly contribution if you can; to max out in 2012, you would have to earn at least $5,000. You will not be allowed to “make up” the difference in later years. I.e. if you put in $2,000 in 2011, the maximum you could put in during 2012 would still be $5,000. You couldn’t put in 8k to cover the three grand you failed to contribute in 2011.
If earn less than $5,000 – be it $500, $1250.36, or $2,016.22 – during a calendar year, that amount will be your maximum allowed contribution.
A number of brokerage firms offer IRA accounts, but many of them have minimum initial deposit amounts (for example, Fidelity’s is $2,500). If you already have a normal brokerage account with a company, they might be cool enough to waive this requirement. Schwab waived the $1,000 initial minimum for my Roth IRA – but only because I already had a Schwab One brokerage/high-yield checking account.
If you don’t have any other accounts and don’t have idle sacks of money sitting about, shop around a bit. If you agree to set up an automatic monthly deposit – say $100 – many brokerages will waive their initial minimum deposit requirements. I’ve had good experiences with Fidelity and Schwab, but there are plenty of options out there.
Finally, if you have a normal stock account, you might be familiar with a lot of the stuff you can invest in: stocks (sometimes referred to as “equities” – if you’re feeling fancy), bonds, mutual funds, CDs (not bad hair-metal records – Certificates of Deposit), ETFs, REITs (Real Estate Investment Trusts) and a bunch more stuff.
Good news – you can invest in all these things in an IRA, thus allowing you to craft a kick-ass, well-diversified portfolio. Of note: some brokerage firms might initially limit your investment options within your IRA account to a few crummy mutual funds. Give ‘em a call and request that they open up the full platter of possibilities – they’ll be glad to do so.
Ok, so a lot of the stuff is the same. But remember those “tax incentives” I talked about earlier? That’s where the bulk of the differences come into play. For some folks, the tax-deferred structure of a Traditional IRA might be preferable; others might like the tax-me-now, not later path that the Roth IRA offers.
Confused? I’m here to break it all down.
The main difference between the two? When you get taxed. A traditional IRA taxes you when you take the money out. If you make $40,000 and put $5,000 in (you are contributing the maximum, aren’t you?), then you only get taxed on $35,000 in earnings.
However, when you withdraw money, you will get taxed on that five grand, plus whatever money you managed to earn on it through your investing skills.
This is good for folks who have a high tax bracket now, but believe they’ll be in a lower tax bracket once they retire. If you’re making 40 large now, but only think you’ll be pulling in a yearly 15k when you’re kickin’ it in Cabo, a Traditional IRA might save you some coin.
With a Roth IRA, on the other hand, you’ll be taxed on the full $40,000 – you don’t get any tax breaks up front. On the backend, though, you won’t get taxed when you withdraw. And, to top it off, the earnings you generate on your $5,000 won’t be taxed either.
So, if you’re an amazing investor or feel that you’ll be in a higher tax bracket later, you might want to go with a Roth IRA. Generally speaking, I’d recommend opening up a Roth IRA, provided you can stomach the upfront tax hit (see the chart at the top). In my simple example, you eat $1400 in taxes up front, but avoid a whopping $43,500+ in taxes on the backend by going the Roth route.
Some Common Misconceptions about Retirement Accounts
A big reason most folks don’t like using retirement accounts is because they feel their money is “locked up” and hard to access. In a Traditional IRA, this is pretty much the case: if you withdraw any cash before the age of 59 and a half, you’ll have to pay income tax plus a 10% penalty on accrued earnings. There are some exceptions for the penalty, including higher education expenses. On the whole, though, your money is pretty much held hostage until you hit the minimum age – unless you’re willing to take a hefty blow.
With a Roth IRA, however, you can pretty much withdraw your principal whenever you want. Why? You’ve already paid taxes on it! Thus, if you want to take the $5,000 contribution out from the above example and buy a jet-ski, you can do it. You won’t be able to put it back in, though, so think carefully about this.
Additionally, any investment earnings on that $5,000 will be subject to taxes plus a 10% penalty if you take ‘em out. So don’t do that.
Once you hit 70 and a half, a Traditional IRA forces you to start withdrawing money – called a minimum required distribution, or MRD. You also can’t keep putting money in. With a Roth IRA? You can keep the money in there as long as you damn well please – and keep on contributing, too (so long as you’re still making a little scratch from one of the three “qualifying income” sources outlined above).
Ok – you might be young (or hell, at least not that old) and be wondering what the benefit to contribution ad infinitude is. Simple – you can use the tax benefits to build a nice inheritance. The Roth IRA offers a wealth of estate advantages over a Traditional IRA. That’s a little bit outside the scope of this article, but if you’re trying to build a legacy or something to pass on to your kids, a Roth IRA is probably a better option.
One last thing: a Traditional IRA can be shifted into a Roth IRA at any time you want. You just have to pay taxes, in accordance with your tax bracket in the calendar year of the change, on the principal.
This process, however, is like a Pokemon evolving: it can’t be undone! You can’t change your Roth IRA back into a Traditional IRA. Making this change, however, might make sense if you like the benefits of a Roth IRA and currently find yourself in a low tax bracket.
If the whole “evolution” thing doesn’t work for you, then remember: you can always have both types of accounts and just split the $5,000 (soon to be $5,500) maximum yearly contribution between the two.
Final Thoughts: Invest While you Are Young and Don’t Turn Down Free Money
For high income individuals (6+ figures a year) and those who receive employer sponsored retirement benefits (i.e. pensions), there may be limits on how much you’re allowed to contribute to either type of IRA. If you fall into one of these areas, call a brokerage firm and ask them about the details – they’ll be happy to help, because they want your business.
If the chart above didn’t convince you to start now, I’ll reiterate an essential point: invest when you’re young! And max it out! Later, if you’re making loads of money, have children or house payments, it might be hard to hit the maximum contribution.
That’s alright – provided you hit that max target when you’re young. Look at how much that $5,000 grew into over 40 years –a whopping 29.2 times the original amount. And that was without depositing another dime. By entering the game early, you give that money many years to grow, thus allowing the magic of compound interest to help you retire in style.
If you’re a little older, that’s no problem at all – but the sooner you start, the more benefit you’ll get from opening either type of IRA. Make a decision, scrounge through the couch cushions and get investing. Your retired self will thank you heartily.