Traditional vs Roth1

Summary

In this financial literacy video, Clark Hayden from Lock, Shield Partners discusses two main types of retirement accounts: traditional pre-tax accounts, such as IRAs and 401Ks, which offer tax deductions now but tax the withdrawals later, and Roth accounts, which lack upfront tax incentives but allow tax-free growth and withdrawals. He emphasizes the importance of choosing the right account type based on one's financial situation and time horizon, highlighting the flexibility of Roth accounts for young savers.

Takeaways

• 💼 There are two main types of retirement accounts: traditional (pre-tax) and Roth (after-tax).
• 📋 Traditional retirement accounts include IRA, 401K, 403b, SIMPLE IRA, and SEP IRA.
• 💰 With traditional accounts, you receive a tax deduction for contributions, reducing your taxable income for the year.
• 💹 The money in traditional accounts grows tax-deferred, meaning you pay taxes when you withdraw funds in retirement.
• 🚫 Early withdrawal from traditional accounts before age 59.5 typically incurs a 10% penalty in addition to regular taxes, except under special circumstances.
• 🌱 Roth retirement accounts do not offer an upfront tax deduction for contributions.
• 🌳 The funds in Roth accounts grow tax-free, and qualified withdrawals are tax-free as well.
• 📈 For individuals starting to save early, Roth accounts offer significant flexibility and liquidity in the long run.
• 💡 The choice between traditional and Roth accounts should consider factors like current and future tax rates, retirement goals, and time horizon.
• 📊 Bill's example illustrates the difference in tax treatment between traditional and Roth accounts, highlighting the impact on income reporting and tax liabilities.
• 🏦 Both types of accounts can be part of an individual's retirement savings strategy, with each offering distinct advantages based on personal financial situations.

Q & A

What are the two basic types of retirement accounts mentioned in the video?

The two basic types of retirement accounts mentioned are traditional or pre-tax retirement accounts and Roth retirement accounts.

What is an example of a traditional or pre-tax retirement account?

Examples of traditional or pre-tax retirement accounts include IRA (Individual Retirement Account), 401K, 403b, SIMPLE IRA, and SEP IRA.

How does a tax deduction work with a traditional IRA?

With a traditional IRA, you receive a tax deduction when you make a contribution, which reduces your taxable income for the year.

Can you explain the example given for Bill's income tax deduction when he contributes to a traditional IRA?

If Bill makes $50,000 per year and contributes $5,000 to a traditional IRA, his taxable income will be reduced to $45,000 for that year.

What are the tax implications when distributions are taken from a traditional retirement account?

When distributions are taken from a traditional retirement account, the amount withdrawn is considered income and is taxed in the year it is received.

What is the penalty for withdrawing from a traditional retirement account before the age of 59 and a half?

If funds are withdrawn from a traditional retirement account before the age of 59 and a half, there is typically a 10% penalty in addition to normal taxation, unless special circumstances apply.

How does a Roth retirement account differ from a traditional one in terms of taxation?

A Roth retirement account does not offer a tax deduction for contributions, but the money grows tax-free, and qualified distributions are tax-free.

What is the main advantage of a Roth account for young savers who have many years until retirement?

The main advantage of a Roth account for young savers is the tax-free growth and tax-free qualified distributions, providing flexibility and liquidity in the long term.

Can you give an example of how Bill's tax return would differ if he contributed to a Roth account instead of a traditional one?

If Bill contributes to a Roth account, his taxable income on the tax return remains at $50,000, unlike the traditional IRA where it would be reduced by the contribution amount.

Why might a Roth-based retirement account be a better choice for someone just starting out with long-term savings?

A Roth-based retirement account is beneficial for those starting out because it offers tax-free growth and tax-free withdrawals after meeting certain conditions, which can be advantageous over a long period of saving.

What are some common types of employer-sponsored plans that can be traditional or Roth accounts?

Common types of employer-sponsored plans include 401K, 403b, and SIMPLE IRA, which can be structured as either traditional or Roth accounts.

Outlines

00:00

💼 Types of Retirement Accounts: Pre-Tax vs. Roth

Clark Hayden from Lock, Shield Partners explains the two main types of retirement accounts: traditional or pre-tax accounts and Roth accounts. Traditional accounts include IRAs and employer-sponsored plans like 401K, 403b, and SEP IRA, allowing for tax deductions on contributions, but taxable withdrawals. An example illustrates how Bill, earning $50,000, would get a tax deduction for contributing $5,000 to a traditional IRA, reducing his taxable income. However, withdrawals are taxed, and there's a 10% penalty for early withdrawal before age 59 and a half. Roth accounts, on the other hand, do not offer tax deductions for contributions but allow tax-free growth and withdrawals, provided certain conditions are met. The choice between traditional and Roth accounts depends on the individual's financial situation and long-term goals.

Keywords

💡Financial Literacy

Financial literacy refers to the knowledge and skills individuals possess to effectively manage their personal finances. In the context of the video, it is the overarching theme as the speaker aims to educate viewers on the different types of retirement accounts, which is a key aspect of long-term financial planning and personal finance management.

💡Retirement Accounts

Retirement accounts are savings vehicles specifically designed to help individuals save for their retirement. The video discusses two main types of these accounts, emphasizing their importance in long-term savings and financial security during retirement years.

💡Traditional or Pre-Tax Accounts

Traditional or pre-tax retirement accounts, such as IRAs and 401Ks, allow contributions to be made with pre-tax income, reducing taxable income in the year of contribution. The video explains that these contributions are tax-deductible, but withdrawals are taxed as regular income, highlighting the trade-off between immediate tax savings and future tax liabilities.

💡Tax Deduction

A tax deduction is a reduction in an individual's taxable income, allowing them to pay less in taxes. In the script, the concept is used to illustrate how contributions to traditional retirement accounts can lower an individual's tax bill for the year, as seen with Bill's example where his income appears as $45,000 instead of $50,000 due to his contribution.

💡Taxable Distributions

Taxable distributions refer to the withdrawals made from retirement accounts that are subject to income tax. The video clarifies that while contributions to traditional accounts are tax-deductible, the money withdrawn during retirement is considered taxable income, which is a critical factor to consider when planning for retirement.

💡Early Withdrawal Penalty

An early withdrawal penalty is a fee charged for taking money out of a retirement account before a specified age, typically 59 and a half. The video mentions this penalty to emphasize the importance of understanding the rules and potential costs associated with accessing retirement funds before the allowed time.

💡Roth Retirement Accounts

Roth retirement accounts are a type of account where contributions are made with after-tax income, meaning there is no immediate tax deduction. However, the video points out that the funds grow tax-free and qualified withdrawals in retirement are tax-free, offering a different financial benefit structure compared to traditional accounts.

💡Tax-Free Growth

Tax-free growth is a key benefit of Roth accounts, where the money invested grows without being subject to taxes on the gains. The video uses this term to contrast the growth potential of Roth accounts with traditional accounts, where investment growth is eventually taxed upon withdrawal.

💡Liquidity

Liquidity in the context of the video refers to the ease with which assets can be converted into cash without affecting their price. The speaker mentions that Roth accounts offer greater flexibility and liquidity, which is advantageous for young savers who may need access to their funds in the future.

💡IRA (Individual Retirement Account)

An IRA is a type of retirement account that individuals can open on their own, independent of an employer. The video mentions both traditional and Roth IRAs as examples of pre-tax and after-tax retirement savings options, respectively.

💡401K

A 401K is a retirement savings plan often sponsored by employers, to which employees can contribute a portion of their pre-tax salary. The video includes 401K as an example of a traditional retirement account, illustrating how it operates with tax-deductible contributions and taxable distributions.

Highlights

Introduction to the video by Clark Hayden discussing retirement account types for long-term savings.

Two basic buckets of retirement accounts: traditional or pre-tax, and Roth.

Traditional retirement accounts include IRA, 401K, 403b, SIMPLE IRA, and SEP IRA.

Tax deduction for contributions in traditional accounts, with taxation upon withdrawal.

Example of Bill's income adjustment due to a pre-tax IRA contribution.

Tax implications of distributions from traditional accounts during Bill's retirement.

Penalty rules for early withdrawal from traditional accounts before age 59 and a half.

Introduction to Roth retirement accounts as an alternative to traditional accounts.

Roth accounts grow tax-free with no tax deduction for contributions.

Bill's tax return example with a Roth contribution versus a pre-tax contribution.

Tax-free growth and withdrawal of funds in Roth accounts.

Advantages of Roth accounts for young savers with long-term saving horizons.

Flexibility and liquidity provided by Roth accounts for long-term financial planning.

Comparison of Roth and traditional accounts for young savers starting out.

Recommendation for young savers to consider Roth accounts due to their benefits.

Emphasis on the importance of choosing the right retirement account type for individual financial goals.

Transcripts

hi there I'm Clark Hayden with lock

Shield partners for a second financial

literacy video and today we're going to

talk about the difference in types of

retirement accounts when it comes to

long-term savings there are two basic

buckets of retirement accounts that you

can save money in the first is called

traditional or pre-tax and this can be

an IRA which is an individual retirement

account or this can be within an

employer sponsored plan of which there

are many types 401K 403b simple IRA SEP

IRA those are just some of the different

types that you could participate in with

your

employer traditional or pre-tax

retirement accounts operate where you

receive a tax deduction when you make a

contribution and the money is taxable to

you when you take it out down the road

as an example let's assume that bill

makes $50,000 per year in he saves

$5,000 in a pre-tax or traditional

IRA that tax deduction shows up as

follows when Bill goes to file his taxes

instead of his income showing up as the

$50,000 salary that he actually made it

will show up as

$45,000 his income is going to be

deducted or lowered by that $5,000 that

he contributed to his retirement account

now the flip side for bill is that over

time as he continues to add to that

account as it continues to grow when he

takes distributions or in other words

when he takes money out of that account

in the future the money that he takes

out will be counted as income in the

year that he takes a distribution so if

Bill takes out a $10,000 distribution

from that account that $10,000 will show

up as income in the year that he takes

it out there are also specific rules for

a pre-tax or traditional retirement

account for when that money can be

received without incurring an additional

tax penalty if those funds are received

prior to your age 59 and a half without

a there are a few special circumstances

but most of the time if they're received

before age 59 and a half there's an

additional 10% penalty on top of the

normal taxation so pre-tax or

traditional that's bucket one bucket

number two is what's called a Roth

retirement account so just like the

traditional you can have a Roth IRA a

you can have a Roth 401k Roth 403b all

these different types of accounts you

can choose to make Roth contributions

inside of those accounts Roth accounts

are the opposite of the traditional

accounts that we just covered in a Roth

account there is no dis there is no

special tax incentive or tax deduction

when you make that contribution but the

money grows tax-free over time so let's

use the same example Bill makes $50,000

per year but Bill chooses to contribute

his $5,000 on a WTH basis instead of a

pre-tax basis when Bill goes to file his

tax return he'll still show $50,000 of

income instead of the 45 that he showed

in the pre-tax example the difference

for bill is that that money that is in

his Roth account is now going to grow

taxfree over time so whereas previously

under the pre-tax example when Bill

takes money out he has to pay taxes

under that Roth money he does not have

to pay taxes on that Roth money as long

as it stays in there for the specified

time frame for young savers who are just

starting out Roth based retirement

accounts are very very very difficult to

be they provide enormous flexibility and

liquidity down the road if you have

years and years of time to save money

you're almost certainly better to use a

Roth based account instead of a

traditional

account