Q&A - Should I Invest in a Roth or Traditional IRA

When it comes to IRAs, do you go traditional or do you choose the Roth path?

It's a common question, and honestly, both have their benefits and potential drawbacks.

In this episode, I break down the complexities of Roth and Traditional IRAs, covering crucial aspects like tax benefits, contribution limitations, early withdrawals, investment options, and more. The aim is to provide you with the knowledge needed to make well-informed financial decisions that align with your future goals.

Don't forget, understanding the specifics of Roth and Traditional IRAs is essential for anyone mapping out their financial future.

Be sure to tune in to the full episode to absorb all the valuable insights and take charge of your financial destiny.

IN TODAY’S EPISODE, I DISCUSS: 

• Tax advantages of Roth IRA and Traditional IRA
• Contributions and withdrawals comparison
• Income and contribution limits breakdown

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Transcript

1:56

All right, welcome to this episode of the Affluent Entrepreneur Show. This one, I get to do one. Of my favorite things in the world, and that is to answer your questions. For me. For me, what brings me joy? I was actually talking to someone recently. About why I enjoy the speaking. And I said, it's not the speaking I enjoy. I mean, I enjoy it, but what. I enjoy is seeing the light and. The twinkle in your eyes when all of a sudden the insights hit. So one of the greatest joys I get to do is to answer your questions, to light the light, to light the path to financial freedom in a way that you get it, that you can go do it, that you can see possibility in your dreams. And that's what we're going to do. In this episode, I am answering a question that came in from Stacey. We're going to talk about Ira accounts. We're going to talk about what's the difference? What are they, what are the things that you need to know and should you be funding? All right, so welcome to this episode of the affluent entrepreneur show. Let's jump right in. Let's do this thing. This is the affluent entrepreneur show for entrepreneurs that want to operate at a high level and achieve financial liberation. I'm your host, Mel Abraham, and I'll be sharing with you what it takes to create success beyond wealth so you can have a richer, more fulfilling lifestyle. In this show, you'll learn how business and money intersect so you can scale your business, scale your money, and scale. Your life while creating a deeper impact. And living with complete freedom, because that's what it really means to be an affluent entrepreneur. All right, welcome to this episode of the affluent entrepreneur show. This one's a fun one because I get to do what I love to do, and that is to answer your questions. And so listen, if you've got any kind of questions around money, around wealth, around finding the path to financial freedom. About building your business or building a rich life, I want you to send them my way. That's what this show is about. That's what we do here is I. Don'T have investments to sell you. I don't have insurance to sell you. I simply want to sell you on. The possibility of your dreams and give you the path and light the way. For you to grab hold of them again. All right, so in this episode, we're. Going to talk about the idea of IRA accounts. What's the difference between an IRA account and a Roth Ira? When do they work? When don't they work? What do you need to watch out for? And should you be even using them at all? And so this question actually came in from one of you, one of the. Community, and it's Stacey who says, what's. The difference between an IRA account and a Roth IRA, and which one is better? It's such a great question. A lot of times we hear these words popped around and we don't know what the differences are. I'm going to break it down for. You in a very specific way. We're going to break down, I don't. Know, ten or eleven factors that we're. Going to compare each account so you. Start to understand the difference on how they work. Is it tax deductible? Can I take the money out? All the things? All right, so let's jump in. Let's really start to dig into it and let's look at it feature by feature so you understand what to look for. So IRA stands for individual retirement account, okay? And a Roth IRA is a specific type of IrA that was created by Congress. It's part of the tax code by a senator named Roth, hence the name, that is unique in the sense that you don't take a tax deduction for it like you do with a traditional IRA and it grows 100% tax free. It's a beautiful account if it works for you, because there are some nuances and there's some limitations that come into play. So let's just look at some of, let's start looking feature by feature. Now, the first is. Which account has tax advantages to it? Okay, well, the Roth IRa, you do. Not take a deduction coming in, but it grows tax free. Okay? So when you take money out at age 59 and a half and beyond, 100% of the money is tax free. In other words, if you put in $6,000 a year for decades and it grows to, say, millions, okay, you didn't. Take a deduction for the 6000 and the millions. When you draw it out 100% tax. Free, you don't pay tax on it. All right? Whereas the IRA, the traditional IRA that. Most people do is you put money in, you take a tax deduction for. It up front, and when you get. The money on the back end, you pay tax then. So what you're doing is you're kicking the tax can down the road. You get tax deferred growth. You don't pay taxes while it's in the account. And when you draw it out at age 59 and a half or beyond, then you'll pay tax. Then the expectation is that hopefully, they. Say your tax rate at the time. That you draw it out is lower. Than the tax rate that you had. When you put it in, and that you actually are playing this tax arbitrage. It may or may not be the case, because who knows what the tax. Rates are or what they're going to. Be a decade or two decades down the road, or even five years down the road, for that matter. But that's the tax advantages of this account. The second feature that I want to. Talk about is this. How are the contributions treated? All right. The money that goes in. So, with the Roth IRA, the money that goes in is after tax. So you get no tax deduction for it. Okay? You get no tax deduction for it. There's no tax benefit on day one. With the traditional IRA, you can put. Money in and you can take a tax deduction for it. It's usually tax deductible. There are some situations where it may. Not be tax deductible. If you're covered by an employer plan and you have income above a certain limit, then you may not get a. Tax deduction for the traditional IRA. But by and large, most of the time, it is tax deductible going in. So the contributions in a Roth are not tax deductible. The contributions to a traditional are typically tax deductible. Then we look at and say the tax deduction. As we said, nothing on the roth. And yes, usually on the traditional, you can get it. Then you look at withdrawals. Okay, here's a little bit of a. Nuance as you start to deal with this. And that is this is that the Roth, you withdraw the money 100% tax. Free after age 59 and a half. There's no penalties, and it's tax free. Now, the money must have been in there at least five years as a. Five year holding period. Now, with a Roth, because you made contributions that were not tax deductible, you. Can always withdraw your contributions out without penalty or tax. I don't suggest it, because then you. Lose the growth and you lose the. Benefits of the growth, the tax free growth over. So, but if you had to, in an emergency, had to access something from the Roth, you could access what you. Put in tax free and without penalty. The traditional, though, however, it is taxable. And you will get penalized if you try to draw it out before age 59 and a half. Now, there are some exceptions and things to the rule that you could potentially do, but the fact of the matter. Is that, by and large, withdrawals are taxable. And if you do it before 59. And a half you'll get hit with a penalty. Federal is 10%, but there are some states that also charge a penalty also. So you could pay ten to 12% in penalties or more. Then you pay the tax. By the time you're done taking out of an IRA prematurely, you'll lose$0.50. On the dollar if you're not careful. Okay, so you want to be careful about it. Now, there's a couple of things I. Want to just bring up here. So you start to look at this and understand it from this perspective. One. When you put money into a Roth, you can only put money into a Roth if your income is below a certain level. So we're going to make sure that you understand the qualifications. You cannot use all of these counts at any time, because the Roth is so beneficial. Because the Roth is something that, hey, it grows 100% tax free, and you take it out 100% tax free, the government is going to limit it. They're going to limit your access to it, and therefore, you don't have the ability to just go into it no matter what. And so what they do is they'll limit it. Now, there is something else I want to touch on before that, and that is this. When you get to a certain age, right now it's 72, okay? The government says, hey, you've had enough. Time not paying tax on your IRA, and so we're going to require you to take money out and pay tax. It's called required minimum distributions, rmds. Okay? And this can wreak havoc for you. In retirement because they'll force you to take money from an IRA that maybe you don't need to take money from and require you to pay tax that. You didn't need to pay. But with a Roth, there are no rmds. So it's a beautiful thing to do is that in a Roth, they can't force you to take the money out. You can leave it in as long as you want. You can transfer it upon death to beneficiaries. It's easier to transfer where you don't have the withdrawal requirements that a traditional IRA has. So one of the things that is beneficial with a Roth is you don't have the rmDs. It makes it easier for estate planning and other transitional planning as you get older. But then you got to look at this and say, well, okay, there are some income limits. And how do I navigate that? Because remember I said, if the Roth. Is so beautiful and so good, and. It is, when it applies, the government's. Going to limit you. So what the government says on the. Roth is that for 2023, your modified. Adjusted gross income, basically your income, if you're single, if it's over $153,000, it's going to start limiting it and eliminate. Your ability to use a Roth. You can't do it for married, it's 228. Now, that's going to go up in 2024. 2024 is single, it's going to be$161,000. So if your income is above 161,000, you may or may not have the ability to go into the Roth that way. And for married, it goes to $240,000 for 2024. So it goes up. But the point is that there are. Some income limitations where you may not be eligible to put money into a Roth if your income is too high. Now, be careful if you happen to be on that fringe where you don't. Know if you're above the limit or. Below the limit, you don't want to. Fund into a Roth and then have to pull out or find that you couldn't fund it because you went over that income limit. So you want to be very much. Aware of where you are, and maybe. You don't fund the Roth until you. Know where your income is to make that happen. So there are income limitations when it comes to the Roth and your eligibility for the Roth. Now. With the IRA, there are no income limitations per se to put money in the IRA, but there are and can be income limitations to take the deduction for it. And what happens is that the trigger is that are you covered by an employer plan? So if, for instance, you happen to. Be in a situation where you have. A work but you want to contribute to your IRA, then they look at. It and say, well, you're covered by. A plan, and therefore they look to your income. So in order to get the deduction, if you're single and your income is above 83,000, you can't get the deduction. If you're married, if your income is above 218,000, you can't get the deduction. So the only time the income limits come into play is when you're covered by an employer plan and your income is too high, so you lose the. Deduction, but you can still put money in at that. So that's where the income limits start to come into play with an IRA. Now, there's also contribution limits. So because these are good. They'Re not. Going to sit there and say, you can put whatever you want in there, whatever you want, they're going to limit it. And the Roth contribution limit and the. Traditional IRA contribution limit are the same. Okay. Currently, for 2023, it's $6,500.$6,500 for either account. If you are 50 or over, then. You can go to$7,500. Now, that's 2023. In 2024, that's going to go up by $500. So in 2024, you can put $7,000. In, and if you're 50 or over. You can put$8,000 in. So there's a contribution limit associated with this. Now, there's also something that I think. I need to make sure is really clear. You can only contribute to these accounts if you have earned income. If you're not getting paid a w, two or 1099, and you don't have. Earned income, then you can't use these accounts. And so your contribution is also limited to the amount of earned income you have if you don't have a lot of earned income. So you want to be aware of that limitation. Next is, are there age restrictions? Well, interestingly enough, there is no real. Age restriction with respect to the Roth. You can contribute at any age as long as you have earned income, like I said. But with the traditional IRA, you cannot contribute after 72 years old if you have no earned income. So you've got to have earned income if you want to contribute after 72 years old. So there are some age limitations associated. With the traditional, not typically with the Roth. Then let's just look at early withdrawal. The last two features I want to touch on. Can you draw money out of the Roth early? And the answer is, yes, you can. You can draw your contributions. Remember, the money you put in, you can take out of the account at. Any time tax free. Don't suggest it, because what happens is. That you lose the money momentum. You're gaining the growth on that money. So we want to leave it in, allow it to grow completely tax free. But if in an emergency, you needed. To access cash, you could access the. Contributions, the amount you put in before age 59 and a half. If you take any of the growth. Or any of the earnings out of the Roth before age 59 and a half, you will be taxed and you will be penalized. Now, with the Roth. Typically, you cannot. Take withdrawals out of any sort before age 59 and a half without penalty and without tax. And like I said, you could lose up to 50% when you add it all up. So I am not a proponent for pulling money out of retirement accounts prematurely because of the tax and penalty you're going to incur on doing it. There are some exceptions and nuanced exceptions there. But by and large, just use the general rule and say once it goes in, it stays in until retirement. Is part of a growth plan. It's part of my financial plan, and it was long term money to begin with, and it has to be an emergency of some sort before you're going to try to get to that money. So hopefully that makes sense. And then the last feature I want. To kind of touch on is this idea of, well, what can you invest in? And really, you can invest in pretty much anything. Even if you go into, they're about the same. You can get into index funds, etfs, you can do reits, you can do all kinds of things. If you put it into a self directed vehicle, you can put it into real estate and other things. So you have a variety of investment. Options available to you based upon who is holding the IRA account, whether it's fidelity, Schwab, or some self directed organization. You will have the opportunity to invest. In a lot of different things. So these are the nuances, these are. The differences between the two types of. Accounts, Roth IRA account and the IRA account. Which one should you use? It depends. One, if I qualify for the Roth. And my tax rate, if I happen to be in a lower tax bracket. Say 25% or below, I'm going to. Probably opt for the Roth, because the. Value of the tax deduction is not. As great as the value of having all that tax free growth in the future. If I'm younger, I may opt for. The Roth because that tax free growth. Is going to be astronomical in the future. If I have too much income to. Qualify for the Roth, then I may. Be forced to go into a traditional IRA. So we end up in that situation. Now, if you happen to be an entrepreneur and in your company, you put in a 401k plan, you can actually. Put a Roth element to your 401k. Plan, and that skirts the income. They don't look at the income side of it. So you have no income limitations. So if you want to put Roth money aside, so you have tax free money at the time of retirement, and you're an entrepreneur, and you have a solo four hundred and one k or a four hundred and one k plan, make sure there's a Roth element in there. You can put your salary deferrals into. The roth part of it, no matter. How much income you have. So those are the things to consider. Stacey, I hope that this helps give you a little bit to think about. I would use this as a checklist and see where you are, which one of these things is important. But now you have this table that you can look at and say, I now know the difference between a traditional. IRA and a Roth IRA. They're both immensely valuable because the idea. Here, remember, when we talk about the wealth priority ladder, I want you putting 25 to even 30% of your income away towards your financial future. We want to eat up that wealth flatline. So you get into the acceleration zone in that. So this is one of the vehicles. To do it with. And you want to get in, you want to stay in, and you want. To allow time to do the heavy lifting for you. All right. I hope that this helps Stacey. And for those of you out there that might have questions like Stacey did, do me a favor. Go to askmelnow.com. Reach out. Leave me your question. Let's bring it on. Let's get you guidance. Let's give you some direction on what. To do so you understand it. Now. Understand this. I don't know your circumstances. I don't know your situation. This is all information I want you to take to your advisors so you. Will be more informed and have a. Better conversation so they can do what's right specifically for you. All right? But bring them to me. Let me give you some unbiased thought. My thoughts on the topic, whether it's wealth, whether it's living a rich life, whether it's money, business, business growth, hit me up. Let's do this thing, all right, until. We get a chance to see each other on another episode or on the road. When I'm speaking, all right, or in the social channels, always, always strive to live a life that lives you. See you soon. Thank you for listening to the affluent entrepreneurship. With me, your host, Mel Abraham. If you want to achieve financial liberation to create an affluent lifestyle, join me in the affluent entrepreneur facebook group now by going to melabraham.com/group, and I'll see you there.