What is an IRA?
Individual Retirement Account (or Arrangements). These are savings vehicles used for retirement that offer some type of tax advantage. Typically, these are set up on your own and not through an employer sponsored retirement plan. You have two types of IRAs, Traditional and Roth. Withdrawals typically cannot be made until age 59 ½ and you can make contributions of $5,500 a year ($6,500 if you’re 50 or older).
This version of an IRA offers upfront tax benefits and is a tax-deferred account. The contributions you make in a given year are tax deductible (reduce your taxable income). So the goal of that money is to grow and grow, and you don’t have to worry about paying taxes on that money until it comes time to make a withdrawal. Anyone can contribute to a Traditional IRA, however, your contributions may or may not be tax deductible depending on your participation in an employer sponsored plan and income level. You can read more about Traditional IRAs here.
This version does not provide any upfront tax benefits. However, your earnings grow tax free and your qualified withdrawals are usually tax free as well (with some limitations). There are income limitations to Roth IRAs when it comes to making a contribution. If your income reaches $117,000 as a single individual your eligible contributions start to become phased-out ($184,000 for married couples filing jointly). Once your income hits $132,000 you are no longer eligible to make contributions ($194,000 for married couples filing jointly). I like the Roth IRA because your contributions to the account can be withdrawn tax free and penalty free before you reach age 59 ½ (although your earnings on those contributions may be taxed). 59 ½ traditionally is the age where you can begin making withdrawals from a retirement account without penalty. Read more about Roth’s here.
The Five-Year Rule – earnings on your Roth IRA contributions will be subject to a penalty if withdrawn before you have been contributing to the account for five years. This rule is in addition to being 59 ½ before withdrawing earnings.
Why I prefer the Roth IRA.
I think it’s a beneficial strategy for young investors. We’re in our lowest earning years, so we’re in a lower tax bracket today then we will be once we reach our 40’s and 50’s. The money you contribute to a Roth IRA has already been taxed, so the goal is to pay tax on the money now when we’re in a low tax bracket vs paying tax on the money later on in life when we’re likely in a higher tax bracket.
Most people will fund their retirement with 401(k) savings, which is a tax-deferred account often offered through employers. If you diversify your types of retirement accounts, you’ll get a mix of tax free and tax deferred income in retirement. This will help lessen the tax burden on your future self.
Below are a few graphs that show the tax results of contributing the same amount of money to a Traditional IRA vs a Roth IRA. I used the average income of millennials in Wisconsin, and since gender wage gap is a thing, I used an average of women’s and men’s income and came up with $32,700. Yes, this is low. Keep in mind this generation spans approximately 20 years, from 1980 to roughly 2000. So the average is based on full-time workers age 16 to 34.
- Age: 25
- Contributions: $5,500 until age 70
- Growth: 7% per year
- Taxes: 15% Federal and 6.27% for state
- Distributions end at age 92.
The program I use (MoneyGuidePro, a financial planning software program) throws in a third scenario of contributing $5,500 a year to a normal non-retirement investment account. Also keep in mind, the income used remains the same throughout the years of contributing. I never said the program was perfect! But still gives you a good perspective. Each graph shows three different accounts. The first bar will represent the Roth IRA account, the middle bar will represent the Traditional IRA with a tax savings component, and the third bar represents the taxable investment account.
It’s not a coincidence that the Roth IRA comes out ahead in all three scenarios. This shows the tax advantage of contributing to a Roth IRA vs a Traditional IRA. Paying taxes later on hinders the growth potential of our savings. You can see why pairing a Roth IRA (a tax free option) with a tax deferred option (Traditional IRA or 401k) isn’t a bad idea. To summarize, I did you a nice and created a comparison table of the main characteristics of a Traditional vs Roth IRA.
Important Disclosures and assumptions:
A note from MoneyGuidePro about the Tax Savings Portion of the Traditional IRA: Tax Savings Amount - In order to make an accurate comparison between the potential value of a Roth and a Traditional Tax Deductible IRA, it is important to consider the current tax savings realized when contributing to the deductible IRA. In our calculations, we show you the effect of investing and reinvesting the tax savings every year that you contribute to a Traditional Tax Deductible IRA. The graph on the next page will show the value of this invested tax savings added to the value of the Traditional IRA as compared to the total value of the Roth IRA over time. We understand that you may not actually invest the annual tax savings when you contribute to Traditional IRA. However, if we were to ignore this component we would not be providing an accurate comparison of the Roth and the Traditional Tax Deductible IRA. * This investment return is hypothetical and used for comparison purposes only. It is not related to any specific investment and there is no guarantee you will actually receive this rate. The results shown reflect annual compounding. Tax rates are hypothetical and used for comparison purposes only. There is no guarantee the tax rates are accurate or appropriate for you, either now or in the future. These results do not include tax penalties, which can occur with disbursements or distributions from Traditional and Roth IRAs prior to age 59 1/2. This calculator does not provide legal, tax, or accounting advice. Before making decisions with legal, tax, or accounting ramifications, you should consult appropriate professionals for advice specific to your situation.
Carolyn Rowland is a CERTIFIED FINANCIAL PLANNER™ passionate about empowering individuals to take control of their financial landscape. “We often tend to place our own priorities on the back burner for others, resulting in sacrifices we don’t often realize we’re making.”Carolyn believes in taking a values-based approach to financial planning. “Together we’ll define what matters most to you, what you want your life to look like, and develop a plan that fits your lifestyle.”
Carolyn Rowland is in the Milwaukee WI, area.