Pros and Cons Of Traditional and ROTH IRA accounts
Looking at Traditional and ROTH IRAs and how I invest in them
Introduction
IRAs can be an amazing tool to invest money for retirement. The younger you are, the tougher it can be to get your head around investing for retirement. But the younger you start investing, the more it pays off.
I am going to do a newsletter soon about getting kids to start investing and what I’m doing. Even though I got my eldest daughter to invest monthly into an S&P 500 index fund, I was met with a lot of skepticism when I pitched a retirement account. I told her that she can start investing in a “Roth IRA for Kids” and how the compounding interest would reap her benefits later. When she asked for more details, I told her she would be loaded by the time she turned 60. That was the end of that conversation.
I can’t blame her, and I was guilty of it. I didn’t start investing in an IRA until I was in my mid-20s. Assuming the market averages 8% a year on the low end, and assuming that the maximum contribution stays at $6,500 a year (it won’t, it goes up every few years), if you were to contribute $6,500 annually into an S&P 500 index fund in a Roth IRA starting at age 18, when you turn 65 years old, your balance would be around $3.4 million. If you start at age 25, your balance at age 65 would be around $2 million. Timing matters.
IRAs can be complicated. There are contribution limits that change every few years, income limitations, backdoor options if you exceed the income limitations, tax benefits and disadvantages and more. I’m going to keep it simple in the first few sections below, but like with anything, make sure to do your own research as this is not financial advice. As always, I’d love to hear your feedback, so please share your comments or tweet me at @TheRajGiri.
There are also ROTH 401K and Traditional 401K accounts that are similar when it comes to taxes, but I’ll cover those in a future post.
A quick reminder that this is not financial advice, just myself sharing my investments, stocks, index fund strategies, what I'm buying, and where I plan to take those investments.
Please subscribe and help spread the word:
Types of IRA accounts
There are a lot of different IRA accounts. In this newsletter, I’m focusing on the two most common, which are the Traditional IRA and the Roth IRA. If you have a business, there are others like SEP-IRAs (which I used to have with my business), SIMPLE IRAs, Self-directed IRAs and others.
With both Traditional and Roth IRAs, you can contribute up to $6,500 a year, or $7,500 if you are aged 50 and older. Outside of that, there are some major differences. My situation is complicated, but I’ve been contributing to a Traditional IRA for a long time. If I could have, I would have taken those contributions each year and done a backdoor Roth IRA conversion to put that money into my Roth IRA. However because I had other IRA accounts (the SEP-IRA for my company), I wasn’t able to do a backdoor conversion.
In my opinion, a Roth IRA is the best way to go. There are people who argue that a Traditional IRA has benefits over a Roth if you’re currently in a higher tax bracket, but I’ll present my argument against that below.
With both types of IRAs, you must have earned income in order to contribute during a calendar year. Earned income is income from employment like wages, salaries, tips and net earnings from self-employment. Dividends, interest, pension, welfare benefits, unemployment compensation and social security are among the types of income that don’t qualify as earned income. So if your income for a given year is from dividends from stocks and social security, you won’t be able to contribute to an IRA that year. Also with both IRAs, the age to withdraw is 59 1/2, although with a Roth, you can withdraw contributions without penalty earlier.
Roth IRAs
Pros
You get tax-free growth. So if you bought $20K of Apple stock in your Roth IRA and it grew to $2 million when you withdraw at retirement, you’re not paying taxes on the $2 million since you had already paid taxes on the contributions. If you instead had that Apple stock in an after-tax brokerage account, you would pay capital gains tax on the nearly $2 million in growth (the growth is $2 million minus the initial $20K contribution).
If something were to happen to you, your beneficiaries would be able to make withdrawals tax-free unless the account is less than 5-years old at the time of the withdrawal.
There are no minimum distributions. You can just keep your money growing in your Roth as long as you’d like without taking a distribution, which is not the case with a Traditional IRA.
Cons
You pay taxes before depositing money into a Roth.
There is an income limit ($153,000 for single filers and $228,000 for married couples filing jointly). If you are above that limit, you can do a backdoor Roth conversion, which I’ll explain below. Below are the income limits, via Nerdwallet:
You can withdraw contributions tax-free. You can withdraw contributions, but not growth. So if you contributed $20K to your Roth and it has grown to $100K, you can withdraw the $20K without penalty.
The maximum contribution is only $6,500 ($7,500 for people aged 50 and older).
Traditional IRA
Pros
Unlike with a ROTH, there are no income restrictions to contribute to a Traditional IRA as long as you have earned income.
You may receive a tax benefit now. Depending on your income, you may be able to deduct your contributions on your taxes. Below are the deduction limits via NerdWallet:
You get tax-deferred growth, although it is not tax-free growth. Using the example above, if you bought $20K of Apple stock in your Traditional IRA and it grew to $2 million, when you withdraw at retirement, you have to pay income tax on the $2 million, whereas you wouldn’t have to pay taxes on that withdrawal with a Roth.
Cons
You pay taxes when you start making withdrawals.
You are required to make withdrawals once you turn 70 1/2.
Unlike with a Roth, you cannot withdraw contributions early without paying a penalty. If you withdraw money early (before you turn 59 1/2), the withdrawals count towards your annual taxable income and you pay a 10% penalty.
Like with a Roth, the maximum contribution is only $6,500 ($7,500 for people aged 50 and older).
Which one is better?
Everyone’s financial situation is different, so definitely do your own research and come to your own conclusions. But for myself personally, with my investment style, a Roth wins hands down. The only times I could see a Traditional IRA being a better solution is if a person is in a much lower tax bracket at retirement then they are now, and there isn’t much growth in the account. The other time a Traditional IRA might be better is if the person needs money in five years or less because there is a five-year rule on earnings in a Roth IRA (more details on that rule are here).
You’ll hear people make the argument that if you’re in a higher tax bracket now and believe you’ll be in a much lower one at retirement, then it’s better to pay the taxes at retirement. Two things:
1) When you make your withdrawals at retirement, those withdrawals count as income which could very likely raise your tax bracket
2) You have to pay the taxes on your growth when you withdraw at retirement, not just the contributions. For instance, if you start investing at 25 and retire at 65 and you're in the maximum tax bracket now (37%), but will be in a mid-tax bracket in retirement (like 22%), sure, you save 15% on your contributions. If we just assume the max contribution is $6500 / year and if you contributed the full amount, your total contributions would be $260,000 and the amount you spend on taxes if you’re in the 37% tax bracket is around $96,000 over 40 years.
BUT... If during those 40 years, you invest in an S&P 500 index fund that returns an average of 8% per year, your balance at 65 is now around $2 million. With a ROTH, while you paid around $96,000 in taxes over 40 years, if you withdraw the total amount, you're not paying any taxes on the $2 million that you have in your account. With a Traditional IRA, if you were to withdraw the total amount, you're paying income tax on $2 million. Assuming you’re in the 22% tax bracket, that’s $440,000 you’ll be paying in taxes. If you remain in the 37% tax bracket, then you’re paying $740,000 in taxes.
Backdoor Roth IRA conversion
If you make too much money to contribute to a Roth IRA, you can do a “backdoor Roth IRA conversion.” With a backdoor Roth IRA conversion, you make your contribution into a Traditional IRA. From there you convert the account to a Roth IRA. You’ll pay taxes on that contribution when you file your tax return.
If you go this route, it’s best to consult with a financial advisor or accountant. There are tax forms that will need to be filled out. Also, as mentioned above, you cannot do a backdoor Roth IRA conversion if you have other IRA accounts, like a SEP-IRA or a SIMPLE-IRA.
Conclusion
Overall, an IRA account is a great way to save money for retirement. A lot of the topics with IRAs can be confusing, so if you have any questions, leave a comment below or send me a DM on Twitter / X at @TheRajGiri .
Because this newsletter ended up being longer than I expected, I’ll do another one this week with step-by-step instructions on how to open a Traditional or Roth IRA account.
Please let me know your thoughts on this newsletter and submit any feedback. You can follow me on Twitter at @TheRajGiri or on Threads at @RealRajGiri . If you haven’t already, please subscribe below: