With tax season in full swing, I think it’s a good time for me to share why I love Roth IRAs and why I think everyone, particularly young people, should set one up today and let the tax-free earnings grow.
If your employer offers it, hopefully you’re taking advantage of a traditional 401k, which allows you to contribute up to 15% of your salary, and that amount is deducted from your taxable wages. For example, if you make $50,000 per year, you can contribute up to $7,500 and your taxable wages will be reduced to $42,500. At that income level, your federal tax bracket is 25%, so instead of paying $12,500 in federal taxes, you’ll only owe $10,625. That’s an extra $1,875 in your pocket each year, plus any match that your employer offers. Unfortunately, you’ll eventually have to pay taxes on the principal as well as any returns when you begin withdrawing during retirement.
Unlike a traditional 401k, a Roth IRA is funded with post-tax dollars, but ALL withdrawals during retirement are tax free. So, in other words, you pay taxes on the principal up front, but all growth is tax free. So lets say you contribute $5,000 per year, beginning at age 30. When you retire at 65, you’ll have contributed $175,000 of post-tax dollars, and if we assume a modest 6% average annual return, you’ll have about $600,000 and all withdrawals will be tax free. You already paid tax on the principal of $175,000 but the $425,000 in returns is absolutely tax free when you withdraw at retirement.
Compare this scenario to a traditional 401k. The $5,000 in contributions each year would be tax deferred, so that saves you $43,750 over the course of 35 years. However, unlike a ROTH, you will owe taxes on ALL withdrawals of both the principal, as well as the estimated $425,000 in appreciation.
|Annual Taxes Paid||$11,250||$12,500|
|Returns at 6% Annual||$425,000||$425,000|
|IRA Balance at Age 65||$600,000||$600,000|
|Taxes Paid on Withdrawals||$150,000||$0|
So there you have it … You would make over $1,000 more per year in net pay by contributing to a traditional 401k because all contributions are tax-deferred, plus you may be eligible for an employer match, but you eventually have to pay taxes on both the principal and any returns at retirement. The ROTH IRA does nothing to reduce your tax liability today because it is funded by post-tax dollars, but all withdrawals are tax free at retirement, so you’ll end up with a lot more money in the long run by investing in a Roth vs. a traditional 401k.
So, how do you setup a ROTH IRA? You can setup an account with most major banks. I set mine up with Capital One (Share Builder) because that’s where I also have my checking account so it’s easy to transfer money. Once you set it up, you can choose to invest your money however you would like. Unlike an employer-managed 401k, which only gives you a few options for investments, you have total control over your ROTH account. Pick individual stocks, mutual funds, ETFs, bonds, etc. You can buy and sell assets inside of your account at any time. However, you can only contribute a maximum of $5,000 per year into the account and there are also income limitations so high earners may not be eligible. Finally, another benefit is that if you need take the money out, you can remove the principal without any penalties. So, for example, after 2 years of contributing the maximum of $5,000 per year, lets say that you have $12,000, ($10,000 principal + $2,000 in returns). If you absolutely need to, you could withdraw up to $10,000 without penalty. However, this is strongly discouraged. Leave that money in and watch it grow!
My advice? Take advantage of both! At the very least, contribute enough into your employer’s 401k to maximize their match (usually 3% to 5%) but contribute the full 15% if you think you can swing it. On top of that, you can contribute up to $5,000 per year into a ROTH IRA. Do this for 30 years and you will be living the good life when you retire. Good luck!