What is an IRA? Traditional vs Roth IRA

Nobody likes to stroke a big check at tax time. In this video, we're going to talk about IRA accounts and why they're probably the most popular way that people reduce their tax bill each and every year. So what is an IRA? IRA stands for Individual Retirement Account. It's an individual account, meaning that you own it all by yourself. It cannot be joined with anybody else. It's also not tied to your employer like a 401k plan would be. It's a retirement account, which means that you're putting money in there, having it grow for your future retirement. So technically, you really cannot touch this money until you're the age of 59 and a half. There are a few exceptions to that, but this money is meant for long-term retirement planning. The IRA itself is not an investment option. What it is, is a shell where you then choose what investments you want to go inside of your IRA. So inside of an IRA, you could choose to invest in stocks, bonds, mutual funds, ETFs, but it's not an investment itself. It is the actual tax shell that goes around your investments. So you could choose to invest money outside of an IRA, which is a non-retirement account, or you could choose to invest money inside of an IRA. And the reason that people choose to invest inside of the IRA is for the tax benefits. So now there are two major types of IRAs. There's a traditional IRA and there is a Roth IRA. So with a traditional IRA, you get the tax benefits upfront. So you get a tax deduction in the year that you make the contribution. This is a popular option for people who might be in the high tax bracket. So for example, if you make $60,000 this year and you contribute the maximum amount, which is $6,000, your taxable income is reduced down to $54,000. So that $6,000 contribution, you don't have to pay any income taxes on. And then the money inside of your traditional IRA is going to grow tax deferred. So you're not going to pay any taxes on the growth year after year. And then once you're retired in the future, that big pile of money that's grown inside of your traditional IRA, you'll begin to pay taxes on it as you take distributions from it. So for example, if you retire at age 62 and you start taking $10,000 out per year, that $10,000 gets tacked on to whatever other ordinary income you have and you start paying taxes on it at that time. Now the second type, a Roth IRA, the tax benefits are really the opposite of the traditional IRA. So with a Roth, you contribute after tax money. So what does that mean? That means that you're not going to get a tax deduction in the year that you make the contribution. So going back to the other example, if you make 60 grand a year and you contribute $6,000 into your Roth IRA, you're still going to pay taxes on all $60,000 worth of income. But the big advantage is that you'll never pay tax on that money again, as long as you follow the rules of the Roth IRA. So the money goes in after tax and then you never pay taxes on it again. 59 and a half is still the retirement age on it. So if you make contributions to your Roth IRA year in year out and that money grows to be a tremendous amount and you start taking distributions at age 62, you'll not owe any taxes on those distributions. So those types of accounts are great for somebody who's in a low tax bracket now because the tax deduction upfront is in a tremendous benefit. They might be in the higher tax bracket later on in life when they're retired and at that point they won't own the income tax for taking this money out. You also don't have to worry about that income pushing you up into higher tax brackets. Say for example, you want to buy a beach home when you're 62 years old and you take out $200,000 of your Roth IRA. You won't owe any taxes on it, whereas in the traditional IRA that $200,000 would be taxed pretty hefty because it's taxed as ordinary income. So it's subject to the income tax brackets. There are also some other pretty big advantages to a Roth IRA. One of them being you can take out your contributions at any time. I love this about the Roth IRA and it's probably the biggest reason that I'm such a fan of it, especially over the traditional IRA. So simple example, when I was younger I started contributing to a Roth IRA right when they came out. I believe it was the mid-90s and by the time I got engaged I had like 10 grand in there and going back I wish I didn't do this, but I was able to take out my contributions. The money that I had put into the Roth IRA couldn't touch the growth, but I could take out the amount that I put in and I used that money later on to buy an engagement ring for my wife. But there could be other reasons that you might want to tap into that money. If you want to start a business, if you have some other investment outside of the retirement world that you want to jump into, like real estate for example. I personally took money out of my Roth IRA to buy an investment property this last year and I was able to take out contributions from my Roth IRA to buy a single family home. So there could be reasons that you want to get money out of retirement accounts before 59 and a half and a Roth gives you some of that flexibility. One thing to remember with IRAs is that you cannot take loans against an IRA. So it does prove to be difficult to get money out of an IRA once you make the contributions. So you really do want to have this money earmarked for retirement. It's not a plan where you say five years down the road I want to withdraw this money for something. It's really money that's going to be long term. Again there are exceptions to get some money out especially with the Roth IRA where you could take out your contributions. But your mindset really has to be that I'm putting this money in there for the long term for once I'm retired you know and I'm going to start making distributions at that time. Another reason that I like the Roth is because there's no 70 and a half rule where you have to take distributions when you reach the age of 70 and a half. That's a big advantage over the traditional IRA. With the traditional IRA the government makes you start taking out money at age 70 and a half because they want their tax revenue. With a Roth IRA there's no 70 and a half rule. So if you don't need the money you could just continue to let it grow inside of the Roth IRA without being forced to take distributions. Now with both IRAs there are income limitations and some quirky rules where you need to do a little bit of research before you make a decision for which one is right for you. So another point that's very important be it a traditional IRA or a Roth IRA is you have to make sure that you're not getting banged with fees inside of your IRA. So a lot of people when they leave a job they'll take their old 401k and roll it into an IRA which could prove to be a very good strategy because within the IRA you have much more control over your investments. So you could pick a low cost provider like Vanguard or Schwab or Fidelity and inside of your IRA you can invest in very low cost index funds to keep the cost down. Where in the 401k you might only have a few investment choices they might be very high cost so it makes sense to roll money from a 401k into an IRA depending on your plan if the fees are going to be lower and if you want to have more control over the investments. So with the IRA you have to make sure that you pick the right partner the right provider that offers low cost options because fees end up being the most important thing inside of these IRAs. So you could pick a low cost provider invest in index funds and just let the money grow for retirement. Another thing that people do is they will convert traditional IRA over to a Roth IRA. So there are strategies behind this so for example if you have all of your money in traditional IRAs what you're able to do is say you know what I'd like to take 10,000 from my traditional IRA and convert it to a Roth IRA and when you do that you pay taxes on the conversion. So let's say you're 30 years old and you have 50,000 in traditional IRAs and you're in a low tax bracket you say you know what I'd like to start getting some of this money over to a Roth IRA. You could say I'm going to take $10,000 and I'm going to convert it to a Roth IRA and then in that year you'll have to pay taxes on that $10,000 so that you convert it over to a Roth IRA and then that money is now in the Roth IRA and it continues to grow tax-free and then when you take it out during retirement it's tax-free withdrawals. I'm also a big fan of tax diversification meaning having different buckets you could have multiple IRA accounts you could have Roth IRAs traditional IRAs and through the years you'll probably end up with these right you'll have 401k plans you know you could have 403b 457 some people end up with all these types of accounts but tax diversification is a good strategy going into retirement because it's nice to have money that you can pull from either side depending on your tax situation each year so you could have money in the Roth money in the traditional IRA and then depending on your income status that year you could decide which one you want to pull from in retirement so it's always a good idea to have tax diversification as well if you do find yourself in the fortunate situation of having too high of an income where you don't qualify for a traditional IRA with the tax deductions and you don't qualify for the Roth IRA there is a strategy known as a backdoor Roth IRA and simply all it is where you make a contribution to your traditional IRA even though you cannot take a tax deduction you make the contribution and then you immediately convert it over to a Roth IRA so this they call the backdoor Roth IRA and it is a good strategy if you're phased out if you don't have an option for the traditional IRA or the Roth IRA because you have too much income so now there are some quirky rules you do want to do research on doing a backdoor Roth IRA before you pull the trigger but it is a good strategy to do so another popular strategy with IRAs is if you have a 401k at your job where you get a match you contribute up to the match and then once you hit the match you stop and you contribute into either a Roth IRA or a traditional IRA again you have to make sure that you qualify based on your income but the reason people do this is because with the IRAs you just have more control you could control the fees better you could control the investment options better with the 401k having the match is great you should take advantage of the match but once you've maxed out on that match going over to the IRA is usually a good decision and then if you're really able to save a lot of money you max out the IRAs for the year which in 2019 is six thousand dollars if you're younger than 50 years old once you hit that six thousand then you go back and you start funneling money back into the 401k and trying to max that out and again this is if you are looking to just invest in you know stock market and mutual fund and ETF based investments like I'll make the argument that I think that it's a good idea to invest outside of these plans and have money that's not just in retirement accounts where you could have money that's in regular brokerage accounts and then outside of that I'm a big fan of investing in real estate so I personally choose to invest in real estate over all of these options because the tax benefits in real estate are amazing but that might not be for everybody so if you're not interested in learning about investing in real estate then a great way to go is invest in the 401k up into the match then max out your IRAs then go back to the 401k and try to max that out as well hope you learned a lot from that thanks for watching please check out schoolofpersonalfinance.com please join my email list so I can send you out whenever I post a new video or a new blog post check out my facebook group get involved in the discussion I appreciate you watching and I will see you again soon thanks