David Salazar April 20th 2019 Wealth MODs 101
Ever since I can remember, I would listen to some guy in a suit on the news mentioned the word IRA. I would hear it from my parents every once in a while, talk about it as if it was their child acting up. I would even listen to that word from older folks in coffee shops, walking down the street or parks. It was safe to say that it was going to be an essential topic when I get older.
Flash forward about 15 years, and I’m now the principal owner of my Wealth Management Firm in Austin, TX. I now spend time talking to individuals about Roth and Traditional IRAs and the differences between the two. My goal when I work with millennials is to educate them on the importance of an IRA and give them a sense of urgency to start investing now rather than later.
The Individual Retirement Account or IRA is like a cousin to the 401(k). It’s a portable
retirement account that is not associated with an individual’s employer. It was designed to have
extraordinary
tax benefits and investment options (stocks, ETFs, Mutual Funds, Bonds, etc.) to enhance the savings that go
into the account, unlike ordinary savings account from a bank. But first, there are some caveats between a
Traditional and Roth IRA.
The three significant differences between the Roth and Traditional IRA all has to do with time. To get a full understanding of the differences, you must be able to ask better questions. Luckily, I can help you with that:
One of the most significant incentives to start investing in an IRA is the tax benefits.
Everyone
must realize that Uncle Sam (the government; for millennials that did not get the reference) created IRAs to
for
the benefit citizens in the United States. However, as the man on the $100 bill once said, “In this world,
nothing can be certain, except death and taxes.” Paying taxes on contributions, regardless of the type of
IRA
account, is something the IRS wants you to do. The only question is when.
Contributions are tax-deductible, and the growth of the investments are tax-deferred. Being tax-deductible means, you can “write-off” these contributions as expenses, thus lowering your taxable income and reducing the amount you owe to the federal government. When will this be beneficial? Let use the 2018 tax bracket for single filers and simple numbers as an example:
Let’s say your total taxable income was $40,000 for 2018. That would put you in the 22% taxable income bracket ($38,701 to $82,500). Now let’s say you contributed $5,000 to your traditional IRA. Your new taxable income would be $35,000 which falls under the 12% taxable income bracket ($9,526 to $38,700). Hence owing less in taxes.
In addition to this nice perk, your savings in the account are tax-deferred. In laymen’s terms, you pay taxes later on any capital gains and interests earned. By later, I mean when it’s time to withdraw, and I will answer that in question 3. However, when you do withdraw from your traditional IRA account, you increase your AGI (adjusted gross income), and you will be taxed at your taxable income bracket for that year. Let us use a similar example like the one up above.
Let’s say your income from working was $35,000 for the year but you withdrew $5,000 from your traditional IRA the same year. That increased your AGI to $40,000, and for simplicity sake, you had $0 deductions. This withdrawal would bump you up to the next tax bracket — no Bueno.
Contributions are not tax-deductible, but growth on the investments are tax-free. You won’t be able to “write-off” these contributions, and you will pay taxes on them now. Even though there is no up-front tax-reward now, you will pay no taxes on contributions and earnings when you withdraw. However, there are some specific conditions you must meet for the withdrawals of gains to be tax-free:
When it comes to discussing your taxes, make sure you consult with a tax professional, lawyer, or CPA.
The other difference in regards to time is asking when and for how long. It is crucial
when
deciding which IRA account you would want to open. There is however a critical caveat when it comes to both
the
Traditional and Roth IRA; You must have Earned Income. According to the IRS, Earned Income is obtained by
participating in a business or trade. In other words, you must be working for someone or yourself. “Gifts”
from
wealthy family members don’t count.
Any person with Earned Income and is under the age of 70 ½ can start contributing. As well as a non-working spouse under the age of 70 ½ who files for a joint return that includes earned income.
Any person with Earned Income can contribute, and there is no limit to what age you can contributing. Plain and simple.
A lot of reasons why individuals would choose one IRA account over another would be due to
the
withdrawing strategies and financial goals one may have. It is also essential to state that you can withdraw
your money at any time, but that may trigger tax implications and penalties.
You can withdraw money from your account, whether it's from your contributions or gains, without incurring a tax penalty after the age of 59 ½. If you withdraw before the tender age of 59 ½, you are subject to a 10% penalty tax. However, there are certain exceptions that you may qualify for to waive the penalty.
There is a financial term that is always thrown around when discussing Traditional IRAs and that is RMDs (Required Minimum Distribution). Remember, Traditional IRAs are tax-deferred (you pay taxes later) that is the day when Uncle Sam says “enough is enough, it’s time to pay your taxes.” The IRS requires you take out a minimum amount at the end of every year starting on April 1st of the year following the year you turn 70½.
As stated before, you already paid taxes on the contributions you made so you can take out your contributions at any time. However, any gains that you take out are taxed if your first contribution to the account was made five years ago and you meet one of the following conditions mentioned above. Let’s use a good example.
Let’s say you started contributing $5,000 to a Roth IRA every year for 20 years beginning at age 30 and there has been an average annual return on your portfolio of 8%. The total amount in your Roth IRA would be $228,810. However, you have contributed a total of $100,000 ($5000 x 20 years). You can withdraw up to $100,000 tax-free. The gains you have made is a total of $128,810 ($228,810 - $100,000).
You are now 50 years, and you decide to withdraw $200,000. How much is subject to a 10% tax penalty? You are right! $100,000 is the correct answer. Now let’s say you waited ten more years and continued to contribute $5,000 annually and there was an average annual return on your portfolio of 8%. The total contribution would be $150,000, but your total portfolio value would be $566,416. How much can you withdraw without incurring a tax penalty? All of it since you are now 60 years old and meet the age requirement of 59 ½.
There are no RMDs during your lifetime. That was easy.
It may seem abundantly clear when answering all three questions, that the Roth IRA is the
clear
choice for Millennials because;
However, there may be certain instances when a Traditional IRA might be more beneficial;
Yes, you heard me right. One disadvantage of the Roth IRA is that there are income limitations in which the IRS will not allow you to contribute at all. For instance, if you are single filer, you can’t contribute to your Roth if you make more than $137,000 in 2019. However, you still contribute to a Traditional IRA or do a backdoor Roth IRA.
Having both is great for tax diversification, and you can contribute to both. However, your IRAs are associated with your Social Security Number, and the total contribution limit ($6,000) can’t be exceeded during the year. For example, you can contribute $3,000 to your Roth and $3,000 to your Traditional for the 2019 tax year.
Regardless of which account you open, always do your due diligence as stated in rule 9 of the MOD Rules. Rightfully choosing the right one takes a lot of planning, but choosing the right investments takes substantially more planning. If you don’t have time or you are unsure about how to even begin, get in touch with a Financial Advisor to help you out with your current situation.
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