Last weekend I got a phone call from my cousin Tootie (not his real name, but a nickname I’ve used for him forever). He’s a junior in college and most of our conversations revolve around sports so I was expecting to get some trouble about Mizzou blowing a 19 point lead against Kansas. Imagine my surprise when he told me that he needed my help settling an argument about Roth IRAs.
He was talking Roth IRAs with a buddy, and his friend said that Roth IRAs are completely tax free. Tootie, being the genius that he is (it’s in his genes), said there was no way something could be completely tax free. He called me to find out which one of them is right.
A Roth IRA SEEMS Tax Free
Tootie’s friend thought a Roth IRA was completely tax free. Some people might say he was right. It sure sounds tax free when you consider the fact that money inside a Roth IRA is not taxed as it grows, nor is it taxed when you take the money out at retirement.
So money in a Roth IRA isn’t taxable and money you take out of a Roth IRA isn’t taxable. So it’s tax free, right?
Wrong.
You Pay Taxes BEFORE the Money Gets in the Roth IRA
The important thing to understand about a Roth IRA is that you can only use earned income for contributions. And as we all know, earned income is subject to federal income tax and state income tax (for states that have one). Depending on your tax bracket and where you live, you could be paying a marginal tax rate of 35% or more when you include federal and state taxes. That’s definitely not “tax free”.
The difference between a Roth IRA and a Traditional IRA is where the money is taxed. A Roth is taxed at the beginning when the money is earned and a Traditional is taxed at the end when the money is taken out, but both are taxed eventually. Uncle Sam wants as much of your tax money as he can get. You can stop him from getting some of your money, but it can’t stop him completely.
A Roth IRA is Still Pretty Awesome!
I don’t want anyone to think I don’t like Roth IRAs. They are super fantastic because they do save you quite a bit of money on taxes. I just wanted to clarify that you won’t avoid paying taxes completely in any IRA, as some people might believe. If you still don’t completely understand the difference between a Traditional and a Roth IRA, I made a little video that explains it completely. Check it out:
Carnival Links
Yakezie Carnival at Financial Success for Young Adults
Canadian Finance Carnival at Canadian Finance Blog
Carnival of Financial Planning at Aaron Hung
Kevin McKee is an entrepreneur, IT guru, and personal finance leader. In addition to his writing, Kevin is the head of IT at Buildingstars, Co-Founder of Padmission, and organizer of Laravel STL. He is also the creator of www.contributetoopensource.com. When he’s not working, Kevin enjoys podcasting about movies and spending time with his wife and four children.
I had this exact same argument with a co-worker. I’m going to point them here to help settle it.
The only thing I would add is you forgot the other great part of a ROTH. No required minimum distributions!
Yeah, there are great things about a Roth. Being completely tax free isn’t one of them though.
I’ll look at your video later, but your article is not emphasizing the potential tax-free growth within a Roth. Let’s say you’re 25, in a 10% federal bracket, maybe a Texas resident with no state tax, and you contribute $5000 one year. You are (yes) funding your Roth using after-tax dollars. But if you keep that money untouched until you’re 59.5, all contributions and growth are yours tax-free – unlike the traditional IRA, where withdrawals are tax-deferred and taxed at ordinary income.
So let’s say that $5000 in your Roth has grown to $50,000 over 35 years (for simplicity, ignoring inflation, and assuming no change in the tax law regarding Roths). You’ve paid $500 tax (a grand total of 1%) on that $50,000. What a greedy federal government, taking as much of your money as it can!
Yep, the video shows all of that. And I don’t know many people who are in the 10% tax bracket and can afford to put away $5,000 in a Roth IRA. That scenario, while possible, seems very far fetched.
If you’re one of the 50% who doesn’t pay tax, then it’s tax free! Tootsie is probably one of these people so tell him to max out Roth IRA now. 🙂
Well that is true, but people who don’t pay taxes usually aren’t the ones who are putting money away in a retirement account. But yes, if you pay no federal taxes on earned income then you are getting your Roth IRA stuff completely tax free.
I think this is your most underrated video. It’s my favorite!
And I love my Roth. Love.
Thanks. I’m a big fan too. Once I start watching it, I always end up watching the full eight minutes.
Well, I just saw your video, and I see you are making my point about the Roth.
There is however one point which you miss, which is that the traditional IRA was designed to be tax-deferred until retirement on the assumption that you would be in a lower tax bracket at that time.
It doesn’t really matter why the Traditional IRA was created; just how it works.
And I prefer the Roth over the Traditional for the same reason you stated earlier (never paying taxes on capital gains).
But the design does have an effect on how it works, because taxpayers in retirement are likely to have lower incomes and thus are paying tax on their IRA distributions at a lower rate than they would otherwise. At least this was the theory at the time, though it may not pertain today to high-income retirees.
You are also missing some other important points about IRAs – one of which is that the traditional type also allows withdrawals without the 10% penalty under 59.5 if you take what’s called “substantially equal periodic payments” based on your life expectancy. Another is the possibility of converting part or all of your traditional to a Roth, if you pay the taxes due at that point. You can even recharacterize the Roth back to a traditional, if say you’re not eligible for a Roth or can’t pay the taxes.
But I would certainly agree that the Roth is ideal for people with the longest time frames, for the reasons already given.
Roth IRAs grow tax free and when you withdraw there are no taxes. That measly $5,000 you contribute 20 years ago grows to a significant number. Will you be in a higher tax bracket when you retire? In most cases, you will be in a lower tax bracket, but you have to hedge your bet.
How about the article you wrote some time back? When we go to a national sales tax your Roth will get taxed all over again, haha!
***** ALSO DONT FORGET ABOUT MLPs. *****If you hold MLPs in an IRA, you might still be on the hook to pay the tax bill (Yes, even in an IRA) if you have over $1000 of UBTI from the distributions.I only mention this Kevin, because I know you like your big dividends, I do too, but be carefull how big if you have any MLP in your IRA.One of my favorite trusts (SDT) is treated as an MLP. My wife has units of it SDT in her IRA… she doesn’t make $1000 on UBTI, and to keep it that way, we don’t reinvest the distributions in SDT, we use them to buy something else.Another common stock that yield lovers are probably familiar with is KMP, also a MLP, so decide carefully before putting it in an IRA.If you didn’t know about this portion of the tax code, your not alone, I don’t think a lot of people do. Use this article at seeking alpha to get you started in your research.http://seekingalpha.com/instablog/847469-the-mlp-investor/136742-should-you-hold-mlps-in-iras-or-401-k-s
This is the first video I’ve watched on your site, and I loved it! Roth IRA= Jean Luc Picard that is awesome! Great job, think I’m gonna watch some more of your videos!