Dire Straits - "Money for Nothing"
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| Naive, yes, but: Cat! |
In the financial chapter of Losing My Religions, I talked about when you should contribute to a Roth IRA vs a traditional IRA. Since then, I have learned some more things. Key lesson at the very end, though.
First, the difference:
For a traditional IRA, you put in what is considered "pre-tax" money. That is, your contributions in a year are subtracted from your taxable income. When you take the money out, it is taxed.
A Roth is just the opposite - you put in income that has already been taxed, and when you withdraw it in retirement, it is not taxed.
The two considerations are the rate of taxes and the total amount of taxes paid.
If you are in a higher tax bracket now than you'll be in retirement, contributing to a traditional IRA will save a higher percentage of your money. Say, for instance, you are in the 27% tax bracket; $1,000 contributed now will save you $27 now, and it will be taxed at, say, 22% or 15% when you withdraw it in retirement.
See comments for why these paragraphs are wrong:
But if you are 30 years old and put $1,000 into retirement investments, that $1,000 should be something like $8,000 when you withdraw it in retirement. Even if you are at a much lower tax rate, you will pay more total taxes on that money if it is put into a traditional IRA.
So my advice now:
The further you are from retirement, the more time your money will have to grow, and thus a Roth IRA is the better deal.
If you are close to retirement and at the height of your earning power (and thus the highest tax bracket), a traditional IRA might be the better deal.
If you are on Obamacare and trying to maximize your subsidy by minimizing your income, a traditional IRA might be more attractive.
However!
A health savings account (HSA) gives you the best of both worlds.
With an HSA, you put in pre-tax dollars (lowering your current taxable income) and when you pull the money out to pay for medical expenses, it is not taxed - not the original contribution and not the growth.
And not just medical expenses in retirement. If you keep track, you can use non-taxed dollars to pay for your bandaids bought today.
And if you don't use the money for medical expenses, an HSA just works like a normal IRA.
Here are a series of videos about HSAs, with this one being the best.
Wish I had known all this 35 years ago!
If you found this post useful, please share it. Thanks so much!
4 comments:
Hi Matt,
I am no longer young but was faced with a decision about whether to start withdrawing from my IRA. My Finacial advisor suggested putting it into a Roth as I withdraw it.
I did the math on IRA vs Roth, and I think you have a flaw in your reasoning for young people.
When you put 1000 into an IRA, that 1000 is tax deductible. 1000 in earnings = 1000 in the IRA. For a Roth, you have to earn, for example, 1300 dollars to put that 1000 into an IRA.
When you take that into consideration, the two options are mathematically equal. There's still the issue of tax rates, but there is not an inherent benefit to one vs the other ceteris paribus.
Cheers,
Tony
Yeah. Sorry I wasn't clear. Example: If our kid at 28 put in 1000 into a normal IRA, they get the tax break for 1000. But if they put it in a Roth, at age 70, it is likely they get a tax break on 20,000. That is, the growth is tax-advantaged.
Thank Matt,
A lot of this depends on how you frame the problem. When you put the frame around a person's overall wealth, all else being equal, the solutions are the same mathematically. Applying tax to the initial earnings vs the growth results in the same outcome. It's strange but true. The approximately 1428 that you need to fund a 1000 Roth ends up being the same as taxing the earnings on tax-free 1000.
So given 1,000 in two IRAs, clearly Roth is better. But to get to that 1000, costs 1428 with a Roth vs 1000 with a normal IRA. In the end, they're the same.
So the Roth vs standard IRA decision then depends on what you believe about tax brackets, rates now and in the future, and the likelihood of having to withdraw some funds before retirement. (That 10% early withdrawal penalty for a standard IRA can bite you).
BTW, I totally agree with you on the HSA. It is one of the great deals out there.
Wow, this is really counter-intutitive. But yeah, holding the tax bracket constant, I just did it in a spreadsheet and see that.
OTOH, you are limited in how much you can put into either IRA every year. So you would be able to put more into a Roth, no?
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