Roth IRA VS Traditional IRA - Which is Better for You?

Hey, financial warriors. In this video, I want to tell you the differences between a Roth IRA and a traditional IRA and help you figure out which one is right for you to put your money in. And trust me, this is gonna be the most entertaining IRA video on YouTube. But first of all, a disclaimer, if you're watching this from Ireland, this video is about individual retirement accounts, okay? IRAs available to US citizens and permanent residents, not anything else. So anyway, there are two types of IRA, okay? So you've got the traditional one, which, because it's traditional, it is the older one of the two. It was established in 1974. And then you have the Roth IRA, named after David Lee Roth from the band Van Halen, and that was established in 1997. Now, I think we'll go through the traditional IRA first. So grab your hat and bow tie and let's go. Now, the traditional IRA lets you contribute pre-tax dollars to an investment account, i.e. you don't pay tax on that money now, but in the future, when you withdraw it from that account upon your retirement, you will pay tax at whatever your tax rate is in the future at that time. So this is gonna be good for you if you anticipate to pay lower tax rates in retirement. Maybe you're gonna earn less in retirement than you're earning now, or you're single now and you anticipate that you will be married by the time you retire, even if you earn about the same amount of money, because people who are married filing jointly actually pay lower tax rates when they earn the same amount of money as single people. Now, you can contribute $6,000 a year to a traditional IRA and 7,000 a year if you are over 50, all right? They give you an extra $1,000 to catch up. You can start withdrawing that money, penalty three at age 59 and a half, and by age 72, you must start taking withdrawals of the money. The IRS has a schedule of how much you have to take from it each year to avoid penalties. If you don't take the money by 72, the IRS will hit you with a 50% penalty, basically a 50% tax on whatever money you were supposed to withdraw in it that year. Now, what happens if you want to withdraw early, i.e. before age 59 and a half? Well, typically, you will have to pay a 10% penalty and also pay the taxes on that money at whatever tax rate you are at. Now, there are some situations where you can withdraw without having to pay the penalty, although you'll still have to pay the taxes. For example, you can withdraw up to $10,000 if you are putting it towards a down payment on a first-time home purchase. And there's a whole list of exemptions, actually, so I'll put some links down in the comments where you can see the full list of reasons that you can withdraw early. Now, if either you or your spouse or both are also covered by a retirement plan at work, that switches you and your IRA's relationship to it's complicated, because although you can still contribute the full $6,000 a year or $7,000 if you're over 50, you will not get the full deduction or you might not get any deduction at all if your income is beyond a certain threshold. There's a load of different variables. Anyway, let's now move on to the Roth IRA. Oh, so the Roth IRA is funded with post-tax dollars, which means you pay taxes on it now, but not when you retire. So from this point of view, we can recommend a Roth IRA to people who are gonna pay higher tax rates in retirement. Perhaps you'll just earn more in retirement, or, you know, 50% of marriages do end in divorce. So from that point of view, you could get pushed into a higher tax bracket because you are now a single filer. I mean, maybe you can rescue yourself with some sort of young trophy wife, but anyway, if you're gonna pay a higher tax rate in retirement, I recommend a Roth IRA. With a Roth IRA, you also don't pay a penalty if you withdraw your contributions early. Isn't that great? You can also pass it on to your heirs completely tax-free. In terms of earnings, i.e. the money you have made on top of your contributions, that would be subject to a 10% penalty if you withdrew it before age 59 and a half, but you can still withdraw it without a penalty for certain things like first-time home purchase, et cetera. Like a traditional IRA, you can also contribute $6,000 a year to a Roth IRA. You can even contribute to both a traditional and a Roth IRA in one year, but it must be a maximum of $6,000 split between the both of them. The Roth IRA does have, though, another significant disadvantage. There are income limits. Like some people, because they are too rich, they are not allowed to contribute to a Roth IRA. Like David Lee Roth himself would be too rich to have a Roth IRA. I don't know why they even named it after him. So if you're single, you can't contribute to a Roth IRA if you earn more than $125,000 a year for the 2021 tax year and $129,000 for the 2022 tax year. And for married filing jointly, if you earn more than $208,000 in 2021 and $214,000 in 2022, you can't contribute anything. So I can't contribute to a Roth IRA, and I think half the financial influencers on YouTube and TikTok who are recommending Roth IRAs to you cannot contribute to them either because they're too wealthy. I guess it's a cool milestone. I'm too wealthy to contribute to a Roth IRA. So traditional IRAs are good for people who would pay a lower tax rate in retirement, and Roth IRAs are good for people who would pay a higher tax rate in retirement. If your tax rate is exactly the same now as it will be in retirement, then it ends up exactly the same. And if you don't believe me, take a look at this example. So take $1,000 and we'll look at the Roth IRA first. Let's say your tax rate is 20%. So we're gonna take out $200 because you've paid the taxes and you've now got $800 to put into your Roth IRA. Let's have that grow at 8% annually, which is about standard for the S&P 500. And that gives us $8,050.13 after 30 years that let's say that's just when we retire and we take that out tax-free. Now, if you had that same $1,000 to invest in a traditional IRA, you can actually put in the full 1,000. So we just put that $200 back because you don't need to pay the taxes. Then when you withdraw after an 8% annual gain for 30 years, you get $10,062.66. But you would now have to pay the taxes at the end. And let's just say that you are taxed at the exact same rate as you were taxed when you were younger, 20%, you would end up with $8,050.13, the exact same amount as from the Roth IRA. Now, that example is based on earning the exact same amount of money and not being able to contribute more to the Roth IRA than the traditional IRA because you are paying the taxes. But if you are in a position where you could max out both, you do actually get more money in the long run out of a Roth IRA. Let me show you the example. If you contribute $6,000, which is the limit, to a Roth IRA at a 20% tax rate, you would need to earn $7,500 to make that $6,000 contribution. So you pay $1,500 in taxes now and nothing in the future. But with a traditional IRA, you contribute 6,000 tax-free for now. Remember that. For 30 years in the market at 8%, they both grow to $60,375.94. But with the traditional one, you're going to end up losing 20% to taxes at the end. So you end up with $48,300.75. Whereas with the Roth IRA, it is $60,375.94 minus the $1,500 you paid in taxes at the beginning for a total of $58,875.94. So the Roth IRA is better for people who are able to contribute the same amount in post-tax dollars to their Roth IRA as they would in pre-tax dollars to their traditional IRA. And your tax rate would have to be considerably higher in retirement to make the traditional IRA make more sense. In addition, the Roth IRA is also better for people who want to make early withdrawals because there is no penalty if you want to take your contributions out early. But in the end, the decision may get made for you because if you're too rich, you're just not allowed to contribute to a Roth IRA and you'd have to go with the traditional one anyway. All right, guys, that is our guide to Roth IRAs versus traditional IRAs in 2022. And remember, if you want to open and contribute to an IRA for the previous tax year, 2021 tax year, i.e. the taxes we are about to report, you can still do that up until April 15th of 2022, okay? You can contribute for last year's tax year and save some money on the tax return that we are about to file, all right? Thank me later for that. And if you do want to open an IRA, check out the investment app, Webull. They provide both traditional and Roth IRAs and you get two free stocks for signing out using my link, which is down below. All right, guys, please subscribe if you're new. Thank you so much for watching and we'll see you next time. Bye-bye.