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The Traditional IRA vs The Roth IRA. How Do They Work, And Which One Is Best For You

August 16, 2021

Let’s talk about how the traditional IRA and the Roth IRA work.

The traditional IRA is called a pre-taxed account. What that means is typically when you put money into a traditional IRA, you get a tax deduction on the contributions.

For example:

  • You throw $5,000 in your traditional IRA.
  • You make $50,000 at your job.
  • You can write off $5,000 of your income and defer those taxes until the future.

That’s why we call it pre-tax.

Traditional IRAs are a bucket of money that you have not paid taxes on yet.

One of the benefits to a traditional IRA is that as you buy and sell investments – whether it’s stocks, crypto or real estate – you don’t have to pay any capital gains tax on the income as you buy and sell them.

The only tax that you would have to pay is when you take distributions out of the traditional IRA. And when you do this, it’s treated as ordinary income to you. You simply add that distribution amount to your modified adjusted gross income and pay normal income tax on it.

It’s a vehicle that allows you to save in taxes because you don’t have to pay capital gains tax as you buy and sell investments. It gives you the ability to grow money faster without it being eaten up through annual taxation. It defers the taxes until the future when you are in retirement age.

If you don’t take a distribution prior to the age of 59 and a half, you don’t have to pay what’s called an “early withdrawal penalty” which is 10%.

One other thing to keep in mind with a traditional IRA is that when you hit the age of 72, there’s something that kicks in called required minimum distributions (RMDs). Basically, you are required to start taking distributions (and pay taxes) out of your traditional IRA, because you owe Uncle Sam a piece of that.

Important to note:

Most traditional IRAs actually come from being a 401k at some point or a 403B or a TRS plan.

You might’ve worked at a company that had an employer sponsored plan set up for you. Many of those employer-sponsored plans like a 401k are typically pre-tax.

When you leave those companies, or have what’s called separation of service, those accounts roll into a traditional IRA. As a result, most people have traditional IRAs versus Roth IRAs.

However, when you’re finally handed that bucket of money, and you’re choosing the investment, you should ask yourself the question: “does it make sense to pay tax now or pay tax later?

From our perspective, if you’re going to grow the account, it might make more sense to pay tax now. That can actually be done through what’s called a Roth conversion. The beautiful part about a Roth conversion is that ever since 2010 anybody can do a Roth conversion regardless of their income.

Prior to 2010, if you made 100K or more, they did not allow you to do a Roth conversion. Nowadays, anybody, regardless of their income, can convert portions – or all – of their traditional IRA, pay the taxes on it, and convert it to a Roth IRA. You don’t have to pay a penalty to do that. You just have to pay the taxes.

If you’re interested in that, we have other classes that talk about the considerations to make when doing a Roth conversion.

The Roth IRA.

The Roth IRA works almost the polar opposite when it comes to taxation. When you make contributions to a Roth IRA, you don’t get a tax deduction, so we call it an after-tax individual retirement account.

Think about it like the money in your back pocket. That’s what you’re left after you’ve paid Uncle Sam your taxes.

So if I throw $5,000 in my Roth, IRA, nothing happens. I don’t write it off on my income – it’s considered after-tax.

Now, as I buy and sell investments, buy and sell stock, buy and sell crypto buy and sell real estate, the investment growth works the same. I get to buy and sell investments within my Roth IRA and pay no capital gains tax as I buy and sell things.

Here’s The Beauty Part…

Here’s the trade-off with the Roth IRA that I think is so advantageous. When you take distributions out of your Roth IRA – if you meet what’s called Qualified Distributions (meaning that you’ve had the Roth IRA open for five years and you’re above the age of 59 and a half) – the distributions are tax-free and penalty-free for the rest of your life.

So, if you’re someone who can take a small amount of money and make it larger, what size bucket would you rather pay the taxes on: the smaller bucket or the larger bucket?

That’s really the question you have to ask yourself. Which one’s better for you – the traditional IRA or the Roth IRA.

Other Fun Facts About Roth IRAs:

The Roth IRA is also different because when you take distributions out of the account, there are Ordering Rules to be aware of.  Ordering rules apply to the set of money that comes out of a Roth IRA when you take distributions.

Since it’s an after-tax account, it works a little differently than the traditional IRA.

When you make contributions to your Roth IRA (since those are after tax contributions) by law, you can take contributions out at any time, tax-free and penalty-free. You don’t have to wait until you’re 59 and a half. So, you can put $5,000 into a Roth IRA, and the very next day take the same $5,000 out without being taxed or penalized.

Generational Wealth

The other benefit with a Roth IRA is if you’re looking to pass on generational wealth. The Roth IRA allows you to do that, especially when you talk about a self-directed Roth IRA that might own real estate or income producing promissory notes. Because the Roth IRA is an after-tax account, when the age of 72 comes, you don’t have the required minimum distributions that you would have with a traditional IRA. You can continue to invest your Roth IRA. Even past retirement years – you can continue to grow it – without being forced by the IRS to take distributions.

A Scenario Showing When the Traditional IRA Might Work Better for You.

Let’s say you’re the type of investor who wants to shovel more money into their retirement account.  You want to put more contributions in so you can get more tax deductions, and maybe the investment growth isn’t that big of a deal to you. You’re more concerned with protecting the principal you put into the account. If your tax deductions outweigh the tax-free growth you’re getting off of the investments, then the traditional IRA might be better suited for you.

When a Roth IRA is a Better Deal for You.

If your goal in making IRA contributions is to create profit through investments, you might realize that the tax-free growth outweighs the tax deduction you get. In this case, the Roth IRA is a better vehicle for you.

The bottom line is that you have both options available, traditional IRA or Roth IRA. It depends on what type of investor you are to decide which one is more appropriate for your situation.

I hope this helped you gain a little understanding of what you should consider before buying real estate in an IRA or a self-directed IRA here at NuView.

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