Roth IRA vs Traditional IRA | Which is BEST for you?

Summary

This video script explores the differences between Traditional and Roth IRAs, highlighting the crucial tax implications of each. Traditional IRAs offer pre-tax contributions with deferred taxes on growth, while Roth IRAs require post-tax contributions but allow tax-free growth and withdrawals. The choice between them hinges on whether one expects to be in a higher tax bracket in retirement. The script also covers early withdrawal penalties, required minimum distributions, income limits for Roth IRAs, and the benefits of tax-free investment growth. It emphasizes the importance of starting retirement savings early to leverage compound interest.

Takeaways

• 📈 Traditional IRAs allow contributions with pre-tax income, growing tax-deferred but taxed upon withdrawal.
• 🌱 Roth IRAs require post-tax contributions, but the growth and withdrawals are tax-free.
• 💼 The choice between Traditional and Roth IRAs depends on your future tax bracket expectations.
• 💡 If you expect to be in a lower tax bracket in retirement, a Traditional IRA may be more beneficial.
• 🚫 Roth IRAs offer penalty-free early withdrawal of contributions, given certain conditions are met.
• 🔒 Traditional IRAs have required minimum distributions (RMDs) starting at age 72, while Roth IRAs do not.
• 💰 Roth IRA contributions can be used as an emergency fund, but caution is advised as earnings withdrawals are penalized.
• 🚫 There are income limits for contributing to a Roth IRA, but not for a Traditional IRA.
• 🌿 Both Roth and Traditional IRAs offer tax-free investment growth during the accumulation phase.
• 💳 The annual contribution limit for both IRA types is $6,000, with an additional $1,000 catch-up for those aged 50 and above.
• 🤔 Deciding between an IRA type should be based on whether it makes more sense to be taxed now or later.

Q & A

What are the two main types of IRAs mentioned in the script?

The two main types of IRAs mentioned are the Traditional IRA and the Roth IRA.

How does tax treatment differ between Traditional and Roth IRAs?

With a Traditional IRA, contributions are made with pre-tax income and grow tax-deferred, with taxes due upon withdrawal. In contrast, a Roth IRA involves contributions made with after-tax income, allowing tax-free growth and tax-free withdrawals.

What is the 'magic age' for penalty-free withdrawals from retirement accounts?

The 'magic age' for penalty-free withdrawals from retirement accounts is 59 ½ years old.

What is the advantage of Roth IRA in terms of early withdrawals?

The advantage of Roth IRA for early withdrawals is that you can withdraw your contributions without penalties, provided the account has been open for over five years, since the contributions were made with after-tax dollars.

What is the main difference between early withdrawal penalties for Traditional and Roth IRAs?

For Traditional IRAs, early withdrawals before 59 ½ incur both income taxes and a 10% early withdrawal penalty. For Roth IRAs, you can withdraw your contributions penalty-free after five years, but not the earnings without penalty.

Can Roth IRA be used as an emergency fund and why?

Yes, Roth IRA can be used as an emergency fund because you can withdraw your contributions without penalties, making it accessible in times of need.

What are Required Minimum Distributions (RMDs) and how do they differ between Traditional and Roth IRAs?

RMDs are mandatory yearly withdrawals that start at age 72. Traditional IRAs have RMD requirements, but Roth IRAs do not, as the contributions were made with after-tax dollars.

What are the income limits for contributing to a Roth IRA as of 2022?

As of 2022, individuals must make less than $144,000 and married couples filing jointly must make less than $214,000 to contribute to a Roth IRA directly.

How do the annual contribution limits for both Roth and Traditional IRAs compare?

The annual contribution limits are the same for both Roth and Traditional IRAs, with a $6,000 limit as of 2022, and an additional $1,000 'catch-up contribution' for those aged 50 or older.

What is the main consideration when deciding between a Traditional and a Roth IRA?

The main consideration is whether it makes more sense to be taxed now (with a Roth IRA) or later (with a Traditional IRA), based on your current tax bracket and expectations for the future.

Why is the tax-free investment growth an advantage for both Roth and Traditional IRAs?

Tax-free investment growth is an advantage because it allows the money to grow and compound without taxation, which strengthens the path toward wealth and financial freedom, unlike normal investment accounts where taxes are paid on gains and dividends.

Outlines

00:00

💼 Understanding Traditional and Roth IRAs

This paragraph introduces the two main types of Individual Retirement Accounts (IRAs): Traditional and Roth. It explains that Traditional IRAs allow pre-tax income contributions, which grow tax-deferred but are taxed upon withdrawal. Conversely, Roth IRAs require post-tax contributions, allowing tax-free growth and withdrawals. The choice between the two depends on whether one expects to be in a higher or lower tax bracket in the future. Additionally, the paragraph discusses early withdrawal penalties, highlighting the flexibility of Roth IRAs, which allow penalty-free withdrawal of contributions after five years, unlike Traditional IRAs that impose penalties and taxes on early withdrawals. The paragraph also touches on the concept of Required Minimum Distributions (RMDs), which apply to Traditional IRAs but not Roth IRAs, and income limits that restrict Roth IRA contributions based on annual income.

05:03

🌱 Common Benefits and Considerations for IRAs

The second paragraph delves into the shared advantages of both Roth and Traditional IRAs, emphasizing the tax-free growth of investments within these accounts. It clarifies that this tax benefit is not available in regular brokerage accounts, where taxes are levied on gains and dividends. The paragraph also outlines the annual contribution limits for both IRA types, set at $6,000 with an additional 'catch-up' contribution of $1,000 for individuals aged 50 or older. The decision between a Traditional and Roth IRA hinges on whether it is more beneficial to be taxed now or in the future, with the Traditional IRA offering an upfront tax break and no income limit for contributions, while the Roth IRA provides tax-free growth and withdrawals. The paragraph concludes by encouraging viewers to consider their current tax situation and future expectations when choosing an IRA, and to start investing early to harness the power of compound interest.

Keywords

💡401k accounts

401k accounts are a type of retirement savings plan sponsored by employers, allowing employees to save and invest a portion of their pre-tax salary. They are named after a section of the U.S. tax code. In the video, 401k accounts are mentioned alongside IRAs as part of a broader discussion on retirement planning, emphasizing the importance of various savings vehicles in preparing for financial security in old age.

💡Health savings accounts (HSAs)

Health savings accounts, or HSAs, are tax-advantaged savings accounts designed for individuals with high-deductible health plans to set aside money for qualified medical expenses. The video script mentions HSAs as one of the financial tools that can be part of a retirement strategy, highlighting the multifaceted approach to saving for both healthcare and living expenses in retirement.

💡Individual retirement accounts (IRAs)

Individual retirement accounts, or IRAs, are a type of retirement savings account that individuals can open independently of their employer. The video focuses on IRAs, explaining their role in retirement planning, and distinguishing between two main types: Traditional and Roth IRAs. IRAs are central to the video's theme as they offer tax advantages and investment growth opportunities for retirement.

💡Traditional IRA

A Traditional IRA is a type of IRA where contributions are made with pre-tax income, meaning taxes are paid upon withdrawal during retirement. The video discusses the tax-deferred growth of funds in a Traditional IRA and contrasts it with the Roth IRA, emphasizing the timing of tax payments as a key differentiator between the two account types.

💡Roth IRA

A Roth IRA is another type of IRA where contributions are made with after-tax income, allowing for tax-free growth and withdrawals in retirement. The video script highlights the benefits of Roth IRAs, such as the potential for tax-free withdrawals and the flexibility of early penalty-free withdrawals of contributions, positioning it as an advantageous option depending on one's tax situation.

💡Tax-deferred growth

Tax-deferred growth refers to the ability of investments to grow in value without being taxed until they are withdrawn. The video explains that both Traditional and Roth IRAs offer this benefit, allowing individuals to maximize their savings by deferring or avoiding taxes on investment earnings during the accumulation phase.

💡Early withdrawals

Early withdrawals from retirement accounts typically refer to accessing funds before the age of 59 ½, which usually incurs penalties. The video script explains that Roth IRAs offer more flexibility in this regard, allowing penalty-free withdrawal of contributions (but not earnings) if the account has been open for at least five years, unlike Traditional IRAs where early withdrawals are generally penalized.

💡Required Minimum Distributions (RMDs)

Required Minimum Distributions, or RMDs, are mandatory annual withdrawals that must be taken from certain retirement accounts starting at a specific age, currently 72. The video script clarifies that Traditional IRAs are subject to RMDs, while Roth IRAs are not, providing an advantage to Roth IRAs by allowing account holders to avoid compulsory withdrawals.

💡Income limits

Income limits are restrictions on contributions to certain types of retirement accounts based on an individual's or couple's income. The video script notes that Roth IRA contributions are subject to income limits, which are designed to prevent higher earners from disproportionately benefiting from tax advantages, while Traditional IRA contributions do not have such income restrictions.

💡Tax-free investments growth

Tax-free investment growth means that the earnings on investments within an account are not taxed until they are withdrawn. The video script emphasizes that both Roth and Traditional IRAs provide this benefit, allowing for the compounding of earnings over time without the erosion of gains by taxes during the investment period.

💡Total Contribution Deadlines and Limits

Total Contribution Deadlines and Limits refer to the rules governing when and how much one can contribute to an IRA. The video script specifies that the annual contribution limit for both Roth and Traditional IRAs is $6,000, with an additional 'catch-up' contribution of $1,000 for those aged 50 or older, illustrating the importance of understanding contribution rules for effective retirement planning.

Highlights

401k accounts, Health Savings Accounts (HSAs), and Individual Retirement Accounts (IRAs) are essential tools for retirement planning.

There are two main types of IRAs: Traditional and Roth, each with distinct tax advantages.

Traditional IRAs allow for pre-tax contributions and tax-deferred growth, with taxes paid upon withdrawal.

Roth IRAs require after-tax contributions but offer tax-free growth and withdrawals.

The choice between Traditional and Roth IRAs depends on whether you expect to be in a higher or lower tax bracket in retirement.

Roth IRAs offer flexible early withdrawals without penalties for contributions, unlike Traditional IRAs.

Traditional IRAs have a required minimum distribution (RMD) starting at age 72, while Roth IRAs do not have RMDs.

Roth IRA contributions can be used as an emergency fund due to their flexible withdrawal options.

Income limits apply to Roth IRA contributions, but not to Traditional IRAs.

Both Roth and Traditional IRAs offer tax-free investment growth, allowing for compounding over time.

The annual contribution limit for both IRA types is $6,000, with an additional $1,000 for those aged 50 or older.

The decision between a Traditional and Roth IRA should be based on your current tax bracket and expectations for the future.

High-income earners may find it more beneficial to contribute to a Roth IRA due to its tax advantages in retirement.

Traditional IRAs provide an upfront tax break and have no income limits for contributions.

Roth IRAs require current taxation but offer tax-free growth and withdrawals in retirement.

Both IRA options can be beneficial for retirement savings, with the best choice depending on individual circumstances and tax expectations.

The sooner you start investing in an IRA, the more time your money has to compound and grow.

Transcripts

In preparing for retirement, you may have heard of 401k accounts, Health savings accounts

or HSAs, and individual retirement accounts or IRAs. Each can play a crucial role in helping

you plan for retirement. In this video, let’s focus on the IRA accounts and the differences

and advantages between them. There are two main types of IRAs, the Traditional

and the Roth. The Traditional IRA allows you to contribute money that has not yet been

taxed. This is considered pre-tax income. Once in the account, your money can grow tax-deferred,

but you’ll have to pay income taxes once you begin to withdraw funds later.

A Roth IRA is where you contribute funds you’ve already paid taxes on. The upside to getting

taxed before putting the money in is that your contributions grow in your account, and

you won’t be taxed upon withdrawing the funds years later.

Major Difference between Roth IRA and Traditional IRA

- Taxes The basic difference between the two accounts

is on when you’ll be taxed. With the Roth IRA, your funds will be taxed before you contribute

to the account, while with the Traditional IRA, your money is taxed at the point of your

withdrawal from the fund. Your choice to make tax payment up-front or

at withdrawal depends on one big idea. Will your income tax bracket be lower in the future?

Your answer to this will be a big determinant of if you use a traditional or Roth account.

If you are in a high tax bracket now but realize that your income generation will be greatly

reduced later, thus putting you in a lower tax bracket, then the traditional IRA would

be better, so that you can be taxed at a later date in a lower bracket. But if you believe

that your tax bracket would be higher in the future, then getting taxed now would be most

efficient and putting after-tax money into a Roth makes sense.

- Early Withdrawals The magic age for withdrawals without penalties

for all retirement accounts is 59 ½. But life hits us all differently, and sometimes

you’ll need access to money in your retirement accounts. Though we typically strongly suggest

not pulling money out of any retirement account, until actually retired, one big advantage

of the Roth IRA over its counterpart is flexible early withdrawals.

Since you contribute to Roth IRA with funds you’ve already paid taxes on, you can withdraw

your contributions (but not any gains) free without penalties as long as it’s been in

the account over 5 years. Why is this? Remember, you contributed to your Roth IRA with after

tax money, so taxes have already been paid on your contributions. Be careful though because

you will incur penalties if you try and withdraw the gains or earnings that your money accumulated.

With the Traditional IRA, you can only withdraw without penalty after you turn 59 ½. Though

you can make early withdrawals, you’ll be hit with income taxes, and most times, you’ll

have to pay a 10% early withdrawal penalty to the IRS.

Lastly, Roth IRAs have an additional potential advantage over traditional IRAs. Since you

can pull your contributed amount early from the account, some may utilize their Roth IRA

as an emergency fund. Once again, we typically suggest that you build your emergency fund

and put it in a high yield savings account, but life happens, and these funds could be

there for you in the event you need some extra cash.

- Required Minimum Distributions Required minimum distributions also known

as RMDs are mandatory yearly withdrawals. At the time of this video, the age where this

is required to start is 72 years old. Traditional IRA accounts (and typically all traditional

types of retirement accounts) have an RMD requirement, while Roth accounts do not have

required minimum distributions. The reasoning for this is simple. You are

not taxed on your money in a traditional account until you withdraw. The US government wants

to be able to tax you at some point, so it requires you to begin to withdraw at a specific

age. Since Roth accounts are funded with post-tax dollars, you are not under obligation to spend

the money in your Roth. The opportunity to ignore compulsory withdrawal is one very big

advantage you’ll enjoy with a Roth IRA.

- Income Limits While anyone can open and contribute to a

Traditional IRA, regardless of your annual income, income limits can prevent you from

contributing to Roth IRAs. For you to contribute to a Roth IRA directly as of 2022, you must

make less than $144,000, and for married filling jointly, that number is $214,000.

This was initially put into place so that highly paid employees weren’t afforded more

benefit than the average earner from the tax advantages the account provided.

Also note, although there is no limit to how much can be contributed to a Traditional IRA,

not everyone can deduct their entire contribution from their taxable income as this is determined

by you and your spouse's income level, as appropriate.

We’ve talked about some of the differences between the two, but there are commonalities

as well. There are rules and advantages to investing in an IRA, regardless of if you

choose the Roth or Traditional route.

Tax Free Investments Growth Roth and Traditional IRAs both come with tax-free

investment growth. Meaning, you’ll have paid the tax before or you’ll pay it later

upon withdrawal, but while the money is growing in your account, it is not being taxed. This

allows your money to grow and compound for many years and decades if you allow it.

This is awesome because in a normal investment brokerage account, you will have to pay taxes

each time you sell an investment and make a gain or each time you receive a dividend.

Allowing your money time to compound without taxation strengthens your path toward wealth

and financial freedom.

Total Contribution Deadlines and Limits You can contribute money to your retirement

account so long as you have taxable income. This is important. Annual contribution limits

are the same for both Roth and Traditional IRAs. As of 2022, this limit is $6,000. If

you are 50 years or older, you can contribute an additional $1,000 in “catch up contributions”.

Now that we’ve discussed the two accounts, you may be wondering which option is best

for you. To be able to answer that, you need to ask yourself a question: “Does is make

the most sense to be taxed now or later?” When you answer that question, you can choose

the IRA type that will give you the best tax savings. This is because if you expect lower

tax rates in retirement, you can choose a traditional IRA that comes with an upfront

tax advantage while if you think the rate will be higher in retirement, you can choose

a Roth IRA with its delayed tax benefits. Remember that Roth IRA contributions aren’t

tax deductible when you withdraw. If you’re in a seemly low tax bracket now, you’re

probably going to save more money in the long run by being taxed now and putting the funds

into a Roth IRA. But with a moderate-to-high tax bracket now, then traditional IRA tax

savings contributions could be the better way for you.

So, a traditional IRA has the upfront tax break over the Roth, and it also has no income

limit, meaning regardless of how much money you make, you can contribute to this account.

For high income earners, or those looking to reduce their taxable income, it is effectively

“cheaper” to save for retirement, as tax savings each year reduce your contribution.

But you will be taxed in retirement. In contrast, the Roth IRA means you’ll be

taxed now, but your contributions and the earnings it makes will grow tax free and will

not be taxed upon withdrawal when you retire. Both IRAs can be very good options for retirement

savings. No matter which one you decide to go with, the sooner you begin to invest and

put the compounding interest rate power to work for you, the better off you’ll be in

retirement. Tell us, do you currently contribute to an

IRA? Which did you choose? If you learned something new today, like this video and share

it with your friends. Make sure you subscribe to our channel and click on that bell icon

to get notified when we drop more content. See you in the next one!