Traditional IRA vs Roth IRA: Which is better for you and your retirement?

Traditional IRA vs Roth IRA: Which is better for you and your retirement?

June 10, 2021
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“Knowledge without action, is like having no knowledge at all!” – Ted Nicholas

Most investors are aware what a Roth and a Traditional IRA account is. For those that don’t know, an IRA simply stands for an individual retirement account (IRA). You can contribute pre-tax or post-tax money into a Traditional IRA account. However, for a Roth IRA, you can only fund this account with post-tax dollars.

Currently, a Roth IRA has a max contribution amount of $6,000 per year, which needs to be made by the following years tax deadline (typically April 15th). All of the earnings in a Roth IRA grow TAX FREE and you can begin withdrawing funds from this account at age 59 ½. Additionally, you can withdraw the contributions, but not the earnings themselves, that you put into your Roth IRA after a 5-year holding period.

Now, $6,000 per year may not sound like enough of an annual investment to build true wealth. However, thanks to compounding interest, if you were to invest $500 / month ($6,000 per year), for 40 years, and earn an average of 7% per year, your IRA would then be worth $1,197,810.67. Consistent investing pays off.

You can plug and play with the numbers using this site.  

There are income limits when it comes to Roth IRA’s. As of 2021, if you make less than $125,000 for a single individual, you can contribute the max $6,000 amount to your Roth IRA. This contribution amount phases out with the more money you make. Therefore, it is vital to max your Roth IRA contributions before you reach the income limitations.

There will always be a debate about which is better: a Roth or traditional IRA. Unfortunately, like most answers in the finance and accounting field, the answer is: it depends. For individuals who believe they will be in a higher tax bracket (i.e. make more income) in their later years, typically a Roth IRA makes the most sense as those distributions will be tax free.

For individuals who are making a lot of money now and expect to be in a lower tax bracket down the line, a Traditional IRA may be best for you. One other thing to note, Traditional IRAs, depending on your income amount, allows you to take a deduction on your tax returns. But when you begin withdrawing from your Traditional IRA in retirement, those withdrawals are taxable.

Both Traditional and Roth IRA’s have been around for some time (traditional IRAs originated in 1974 & Roth IRAs originated in 1997). To date, they have helped many people save for retirement and make a great investment doing so.

But not as many people were able to have the success story like famous investors Peter Theil and Max Levchin. Peter Thiel and Max Levchin are both self-made billionaires, mostly known for co-founding PayPal. Both of these individuals allegedly built $90+ million Roth IRA accounts.

How were they able to do this if the max contributions are only $6,000 per year?

Well, both investors most likely set up self-directed Roth IRAs which allows investors to hold a variety of alternative investments that most IRAs can’t own, including non-publicly traded companies. In this case, that included buying shares in PayPal and Facebook, prior to those companies going public, inside their retirement accounts.

Now imagine having $90+ million in a Roth IRA and paying $0 in taxes? Must be nice.

Key takeaway’s: Make sure you are aware of your current retirement plan with your employer. Even if you already have a 401k plan, opening an IRA account could make sense for you. If you do have a Roth IRA, it may make sense to put investments with the highest growth potential in your Roth.  That way, if they do turn out to be home runs, you can enjoy those returns without paying taxes. Finally, if you are funding your IRA accounts, make sure that money is being invested right away! You would be surprised at the number of people who fund their respective plans, and that money just sits in cash.


Disclosure:

This material is for general information only and is not intended to provide specific advice or recommendations for any individual.

Contribution to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a  10% IRS penalty tax. Limitations and restrictions may apply.