IRA Part # 1 | What is a Roth IRA | Difference Roth and Traditional | Advantages of Going Roth

by RJ

in Investing

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Looking for an easy way to become a millionaire?

Our generation has things pretty easy. Our parents grew up thinking that their employer and their government would take care of them in retirement. The only vehicles for tax-deferred retirement savings were expensive annuities and life insurance contracts.

We’re very fortunate.  Instead of living years under a false pretence, we realize at a young age that saving for retirement is our own responsibility.

One of the smartest and simplest ways to build wealth over your lifetime will be in a Roth IRA.

This is the beginning of a 3-Part series on the Roth IRA.

What Is A Roth IRA?

A Roth IRA isn’t an investment; a Roth IRA is an account that you’re entitled to put money into. The money contributed gets invested in things like stocks and bonds and grows tax-free over your lifetime.

The biggest advantage of the Roth IRA is the tax-free growth. Compared to a Traditional IRA or 401K, there are no taxes once the money is withdrawn after a certain age.

The tax-free growth makes a dramatic difference when compared to investing outside of a Roth IRA.

IRA VS Taxable Account

  Roth Taxable
Age 20 20
Marginal Tax Rate 25% 25%
Rate of Return 10% 10%
Yearly Contribution $5,000 $5,000
Total at 65 $3,953,977 $1,784,847

Here’s the calculator, so you can see the difference.

Difference Between Roth IRA and Traditional IRA

For the majority of us, there are two types of IRAs; Traditional and Roth. In a Traditional IRA, in the year you contribute money you receive a tax-deduction. When you withdraw your contributions, your entire withdrawal including the principal, is taxed as ordinary income.

There is no current year deduction for contributing towards a Roth IRA. However, no portion of your withdrawal is taxed after you get to a certain age. This is the primary difference between a Roth IRA and Traditional IRA.

There is much debate when it comes to which IRA is a better. I will argue that for 99% of Gen Y investors, a Roth IRA is a better investment.

Unless you’re planning on making less or Congress reducing taxes, your tax rate is going to go up over your lifetime. Chances are your current income tax rates are as low as they will be in quite some time. Therefore, it makes sense to pay a little more in taxes now (by forgoing the current year tax deduction you get from a Traditional IRA) than running the risk of paying huge amounts of tax down the road.

Roth IRA Advantages

The tax-free growth isn’t the only advantage to investing in a Roth. There are more incentives to encourage individual investors to save.

  • Value Of Contributions - Which is greater, $1,000,000 invested in a Roth IRA or $1,000,000 invested in a Traditional IRA?  If you want to withdraw $10,000 of income out of a Roth, all you need to do is sell $10,000 of your investment. However, if you wanted $10,000 of income out of a Traditional IRA, you need to sell more to cover the taxes. If your ordinary income tax rate were 25%, you would need to sell $13,333 of your investment. Even though the amounts you can contribute each year to a Roth and Traditional IRA are the same, a Roth IRA has more value.
  • No Minimum Distribution Rules - After years and years of tax-free growth, the IRS is going to want its share eventually. Once you reach 70 1/2 in a Traditional IRA, there are requirements on what you must withdrawal each year. In a Roth IRA, since the IRS has already received its share, there are no laws about the minimum you must withdrawal.
  • Flexibility of Principal - At any time you may withdraw the amount you contributed to a Roth IRA tax and penalty free. While not recommended in most circumstances, this can become useful if you find yourself in extreme financial hardship.
  • Restrictions on Roth and Traditional IRAs - Both a 401K and Traditional IRA give you a current year tax deduction. Since the IRS wants you paying some tax this year, there are certain restrictions on contributing to both a 401K and Traditional IRA.

Disadvantages to Roth IRAs

Besides contributions not being tax deductible, I see two disadvantages with Roth IRAs.

Right now, a Roth IRA is one of the easiest ways to build wealth. However, at any time Congress can change their mind on the taxation of these accounts, for example taxing a portion of the withdrawals. Not very fair, but it could happen.

Choosing to invest in a Roth IRA over a Traditional IRA is like placing a bet that your tax rates will rise. If your tax rates go up, you win. If tax rates go down, you lose.

Both disadvantages are out of your control. You can either sit around waiting to see if the tax laws change or start investing. Based on what I know about compound interest, I would start investing.

Who Is Eligible To Invest In A Roth IRA?

No matter the age, as long as you have earned income, you can invest in a Roth IRA.

In 2009, the maximum contribution is $5,000. If you have earned less than $5,000 in 2009, you’re only allowed to contribute up to your earned income. I.E can only contribute $2,500 if you have earned $2,500.

High earners are also limited to how much or even if they are allowed any contributions at all. Once your income starts reaching certain levels, your maximum contribution begins to be phased out. Your phase-out limit is based on your MAGI (Explanation of MAGI).

In 2009,

  • Single filers – Anyone with a MAGI less than $105,000, is eligible to contribute the maximum amount. Phased out contributions are allowed for MAGIs between $105,000 – $120,000. If you’re single and earned above $120,000 you’re not entitled to contribute to a Roth IRA.
  • Joint filers – Joint filers are allowed a full contribution if MAGI is less then $166,000. Phase-outs begin for those with a combined between MAGI of $166,000 – $176,000. If you’re filing jointly and have a combined MAGI of over $176,000, you many not contribute to a Roth IRA.
  • Married filing separately – Don’t expect to build wealth through a Roth IRA if you plan on filing separately from your spouse. Phase-outs begin at an MAGI of $0 and contributions are completely phased out at $10,000.

This is the first in a three part series of the Roth IRA.

Photo by: Sieana♥s TokioHotel’s

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