Starting Young: Traditional Versus Roth IRA
Tennessee Williams once said, “You can be young without money, but you can’t be old without it.” These words are very true, especially in today’s high cost world. I recently was reading an article written by the Huffington Post titled “22 Percent of Americans Would Rather Die Than Retire Without Enough Money.” The article went on to discuss the depressing state of retirement in America and the survey responses that pose an early death as a viable alternative to comfortable retirement. Then the statistics came: 19% of middle-class Americans have zero retirement savings, 34% are not currently saving for retirement and 41% of Americans between 50 and 59 are not currently saving for retirement. I wish I could say I’m shocked by these results.
More times than not I talk with people, of all ages, who have put retirement savings on the back burner. Many have the mentality that it is better to take what you can get today because you can’t be sure it – or you – will be around tomorrow. As this can be true in some cases, this doesn’t take away from the fact that eventually you will come to a point where you need a financial plan (marriage, children, retirement, emergencies, taking care of parents, etc.). My grandmother once said, “starting to save earlier rather than later will always help out in the long run, but it will never be easy if you don’t start.” This is where my inspiration came for this article. I want to continue spreading and educating others on the importance of investing for their future. Not only because it is my job, but because I want to play a role in shaping the financial culture for my generation and the future generations and legacies we leave behind.
This brings me to my point. About six months after I was out of college I found myself in a chair at HFG Trust – formerly Haberling Financial Group. I was introduced to a whole new world of savings, specifically investment accounts. My college journey had led me into a finance degree I loved, but never gave me the insight on how to really start investing in my future. The only thing I knew was that I needed to start somewhere. In order to select the best account for me at the time, I started researching the difference between a Traditional IRA verses a Roth IRA. I soon realized that there are a few major differences. Here are some key considerations to review in order to make the best decision for you:
Determining Which Account is Better for You:
Taxation: Difference Between a Traditional & Roth IRA
One of the biggest differences between a Traditional IRA and a Roth IRA has to do with how they are taxed. They both include generous tax breaks, but it’s a matter of timing on when you get to claim them.
Any money contributed to a Traditional IRA is counted as a tax deduction on both state and federal tax returns for the year the contribution occurred. Essentially, this gives you an immediate benefit as it lowers your taxable income for the year. However, when retirement comes and withdrawals occur they are taxed as ordinary income tax rates.
On the flip side, contributions put into a Roth account are not deductible, but earnings and withdrawals are generally 100% tax-free.
Marginal vs. Effective Tax Rate
The decision between a Traditional IRA and a Roth IRA are based around the same question, do you expect to be in a higher tax bracket now or when you start taking distributions? Let’s take a closer look:
- If your marginal tax rate is higher in the year of contribution, the Traditional IRA wins.
- If your marginal tax rate is higher in the year of distribution, the Roth IRA wins.
- If your marginal tax rate stays the same, you will have the same amount of money in the Roth and Traditional IRA accounts.
Keep in mind, just because you fall into the category of one of the options addressed above, doesn’t mean it stands completely precise. We will need to observe the difference between marginal tax rate and effective tax rate, to help illustrate real world application.
Marginal Tax Rate
This is the percentage of tax applied to your income for each tax bracket in which you qualify. For instance, let’s assume someone who files as a single person tells you they make $60,000 so they are in the 25% tax bracket. This doesn’t mean that all of their earned income is going to be taxed at 25%, it just means that this is the percentage category their income falls into. The marginal tax rate is the percentage taken from your next dollar of taxable income above a pre-defined income threshold.
Effective Tax Rate
The effective tax rate, or average tax rate, is the percent of taxes paid over your entire earned income. It is derived by dividing the total tax by earned (gross) income. For example:
Let’s assume you are a single 30-year-old earning $60,000 per year. Based on the 2017 tax rates we see the following:
To further examine the taxable income of $49,650:
If we take $8,151.25 (total tax liability) divided by $60,000 (gross income) we see that this individual’s effective tax rate is 13.58% and their marginal tax rate is 25%.
Future Tax Rates:
Trying to predict federal and state tax rates years from today doesn’t seem like a good use of time, but there are some questions to help define your personal situation. Examples include but are not limited to the following:
- Which federal tax bracket are you in today?
- Do you expect your income to increase or decrease throughout retirement?
- Do you expect your tax rate to be higher or lower when you retire?
There will be cases where gross income could decline in retirement, but taxable income may not. For example, the kids are no longer dependents, you’ve reached retirement so you will no longer be contributing into your pre-tax account and so forth. These tax deductions and credits that you are now losing may leave you with a higher taxable income in retirement.
A Traditional IRA allows you to start taking penalty free withdrawals beginning at age 59½ and eventually requires you to start taking required minimum distributions (RMDs) at age 70½. If you choose to withdraw funds prior to age 59½ you will be subject to a 10% penalty in addition to applicable federal and state taxes. Of course, there are certain circumstances where you may be able to avoid the penalty on the early withdrawals. To note a few:
- You can withdraw up to $10,000 without the normal 10% early-withdrawal penalty to pay for qualified first-time homebuyer expenses, but you’ll pay taxes on the distribution.
- Death or disability
- Qualified education expenses
A Roth IRA doesn’t have required distributions during the owner’s lifetime. The contributions can be withdrawn at any time, tax-free and penalty free. This means that if you don’t need the money, the account can continue to grow tax-free throughout your lifetime. In addition, there is the five-year rule. This rule tells us that a withdrawal from a Roth IRA will only be classified as a qualified distribution if it has been at least five years since you first opened the account and began contributions. For example, if you are 63 and you made your first contribution at age 60, you have to wait until age 65 to withdraw any earnings made on that portion of the original contributions. You are also allowed penalty-free withdrawals from the account for assets reserved toward college expenses for the account holder or practically anyone in the family lineage.
There may be variables that make a specific situation different from the general policies that are mentioned above when it comes to determining which way to invest. Avoiding RMD’s and having tax-free withdrawals later on may lead you to think that a Roth IRA is the better selection here. But there is still a comparison of current verses future tax rates that needs to come into play. The point being, for young investors the Roth IRA may be more favorable in many situations, but not all.
The most important decision you can make today is getting started. It is never too late to start. Take the time to invest in your future or develop a game plan to get you headed down the right track. If you would like more information on the topic discussed or would like guidance on developing a financial plan, please feel free to reach out to one of our HFG Trust advisors.
■ Brianna Brannan
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