Roth vs Traditional IRA Taxation
Discussing retirement strategies at sunrise on O’Caulkins Lake in the White Clouds Wilderness
It is sunrise at O’Caulkins Lake in the White Clouds Wilderness, somewhere behind that ridgeline that's called the Chinese Wall. Somewhere down there the sun is peeking over the horizon, although we can't see it up here yet. If you take a look at this ridgeline, there are three peaks here: Caulkins Peak, WCP-9, and the Egyptian pyramid-looking one in the distance is D.O. Lee Peak.
It is a beautiful day to hopefully share a little education with you about Roth IRAs and Traditional IRAs, and what the tax differences are between the two.
How Hourly Financial Planning Clients Can Understand IRA Tax Benefits
We’ll cover three areas really quick in the next couple of minutes. First is when you're putting money into these accounts. With your Traditional IRA, or with your 401(k) (it works the same), you get a tax deduction upfront. So you put money into the account, you get a deduction on your tax return, you end up with less tax on the return and therefore more money in your pocket to do whatever you want with.
With a Roth IRA, when you put money into it, there is no tax deduction. So you're putting after-tax money into the account.
Tax Treatment While Money is in the Account
The second area to cover is what happens while the money is in the account. In both cases you can buy, you can sell, you have income, interest, and dividends, and you do not have to pay taxes as you go along your way with these accounts.
The big differences come when you're going to pull money out of the accounts.
Withdrawal Rules for Hourly Financial Planning Clients
Now they're Individual Retirement Accounts—IRAs—so the government wants you to leave the money in until you're 59 and a half.
Traditional IRA Withdrawals
With a Traditional IRA, if you pull money out before you're 59 and a half (except for a couple exceptions), then the government's going to charge you ordinary income tax as well as a 10% penalty.
If you wait until you're 59 and a half, then you're free to get the money out, but you still have to pay ordinary income tax on this money. No capital gains apply here, no preferential capital gain rates—it’s ordinary income tax rates.
And then lastly, the government will require you to start taking money out of this account when you're 70 and a half years old, whether you want to or not.
Roth IRA Withdrawals
Now with the Roth IRA, it's a little bit different. You've put money in that's after tax, so even before age 59 and a half you can take your contributions out without a penalty.
It's only the earnings that you're going to have a problem with. So if you put $5,000 in and it's grown to $6,000, you can pull that $5,000 out at any time without any penalty. But if you're younger than 59 and a half and you pull out that $1,000 of earnings, then you'll have to pay the income tax and the 10% penalty, unless you qualify for some of the exceptions.
Now after age 59 and a half, this is where it's really different. With the Roth IRA, you don't have to pay any tax at all, ever. And the government will never require you to take money out of this account.
So it is a great tool to prepay taxes for retirement and retire with a tax-free account, where you know that you're going to get every dollar that's in there and it won't mess up your taxes for Social Security or any of those negative effects.
Thanks for being with me this morning.