About this video
Sal compares a traditional IRA with a Roth IRA for $5,000 of savings. A traditional IRA puts in the full $5,000 untaxed and is taxed on withdrawal; a Roth is taxed upfront (leaving $3,400 at 32%) but withdrawn tax-free. With the same tax rate both give $6,800, so a traditional IRA is better if your future tax rate is lower, while a Roth offers more flexibility to take out what you put in without penalty.
You'll be able to
- explain when the tax is paid in a traditional IRA versus a Roth IRA.
- show that both give the same result when the tax rate stays the same.
- decide which IRA makes more sense based on future tax rate and need for flexibility.
Key words
- Roth IRA
- A retirement account you fund with already-taxed money and withdraw from tax-free in retirement.
- Traditional IRA
- A retirement account you fund before tax and pay tax on when you withdraw.
- Incremental tax rate
- The tax rate on each extra dollar you earn in your current bracket.
- Penalty
- An extra charge, such as 10%, for taking money out of a traditional IRA before 59 1/2.
- Earnings
- The growth on the money you put in, as opposed to the amount you put in.
Transcript
- [Instructor] In this video, we are going to describe Roth IRAs. IRA stands for investment retirement accounts, so you can imagine it has something to do with retirement. And Roth is named after Senator William Roth right over here, who sponsored the legislation that allowed Roth IRAs to exist.
So let's give an example to help make clear what even IRAs are, but especially Roth IRAs. So, let's say, I am working right now, I have not retired. I'm younger than 59 1/2 years old. And I have $5,000 that I would like to save for retirement. I could save it in different ways.
But let's say the two ways that I'm looking at are a traditional IRA, but my other option is a Roth IRA. And there are limitations on how much I could put in my IRAs, et cetera. I'm not going to go into those details in this video. But the big difference between a traditional IRA and the Roth IRA, they both have tax benefits, but it's when you get that tax benefit.
So in a traditional IRA, when you put the money in initially, that money is not taxed. So, let's put, say the initial amount. When you put it in the traditional, you can put the whole amount, $5,000. Roth IRA, you are going to be taxed on it. So this $5,000 is going to be taxed before we put it in there.
And let's assume that we have a 32% incremental tax rate on every incremental dollar that we're in that bracket now. It's not 32% on all of our money, but on that increment we're in the bracket, that would be 32%. So, if we have to pay 32% taxes, federal income tax on that $5,000, 32% of 5,000, that means that 1600 is going to go for taxes.
And the remainder, that is, what? That is going to be $3,400, is going to be the principle or the amount that I can initially put into that Roth IRA. So, right now, Roth IRAs aren't looking so great, but they can start to look good if we fast forward into the future.
Let's say, we are going +10 years or 20 years, you could pick the time. And let's say we are now retired, we are over 59 1/2 years old. Why do I use this very strange age? Well, the tax code says that's the age at which you can start to use either of these IRA, either of this money without paying any type of penalty, and you can use it for retirement.
So in +10 years, you wanna take that money out. So you need for retirement. So in a traditional IRA what's going to happen is, is when you, well, let's just... Well, before I even talk about how much you're gonna be able to take out, let's say that they've both sat in the same investments 'cause we wanna make an apples to apples comparison.
And those investments, we were able to get two times our money. So the money has essentially doubled over that 10 years. So now it is $10,000 in the traditional IRA, and it is $6,800 in the Roth IRA. So when we take it out of the traditional IRA, this is the time that we are going to pay taxes.
So for us to get it out, we are going to have to pay taxes here. While in the Roth IRA, we can just take it straight. We have to pay no taxes. So for the Roth IRA, that $6,800, we can use directly for retirement. In the traditional IRA, if our tax rate is still 32%, an increment, 32%, well, if you had to take 32% of $10,000, that would be $3,200 would go to taxes.
$3,200 would go to taxes. And then what would I be left with? $6,800. So, I know many of you are now scratching your heads. You're saying, "These things look fairly similar. What's the difference in the end of the day?" Well, traditional could make sense is if you think at retirement, you're going to pay less than a 32% incremental tax bracket.
That might make sense because you're not gonna be working anymore. You might have a less total income in a given year. And so that incremental bracket might be lower. And so, if you're paying less than 32%, when you are retired, then this scenario might look better because you're going to get more than $6,800 back.
And now you're scratching your heads and say, "Why did William Roth go through the trouble of the Roth IRA then?" Well, the Roth IRA has other advantages, and a lot of it is based on what happens in between the time that you put it in there and when you take it out.
For traditional IRA, there's a pretty significant penalty if you take it out before you are 59 1/2 years old. You have to pay a 10% penalty on whatever you take out, and you have to pay taxes. In the Roth IRA, because you've already paid taxes on it, If you take out no more than the principle amount, than that $3,400, so the things that aren't earnings, then you can just take it out penalty-free.
So the benefit of the Roth IRA is if you take it out before 59 1/2, there is more flexibility. They are still... It's still not quite as much flexibility if you just put it in a bank account or in a traditional investment account, you still have to make sure that you are meeting the constraints of it.
But as long as you're not going above the $3,400, you aren't paying a penalty. Now, if you go above the 3,400, and you're taking out some of the earnings, now you're gonna have to start thinking about above and beyond what you might have to pay. But big picture, traditional IRAs make a lot of sense if you think that your future tax rate is going to be lower than your current tax rate.
Roth IRAs make a lot of sense if you need a little bit more flexibility with that money, you think you might need it, but you're not sure, and you would still like to save it for retirement. These are both really good because once they're in these accounts, you can buy and sell investments and stocks and other things, and you're not going to pay capital gains or income tax while they are sitting in those accounts.
So that's the other really big benefit of this.
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