Literally no one has ever asked me what the difference is between a Roth IRA and a Traditional IRA.  I’m not great at the economics of supply and demand so I’m going to write an article about it.  Understanding the difference between these two accounts is like eating broccoli.  Only like three people in the continental United States like broccoli, but it’s important to eat it for reasons nobody is sure about.

It’s important to know the difference between the various IRAs because you’re supposed to be putting money into your retirement accounts.  If you were doing that, then you’d eventually want to know which retirement account you should put your money in.

So, what is an IRA?

IRA is short for India Red Ale.  It’s like an India Pale Ale except it’s less hoppy and it’s red.  IRA also stands for Individual Retirement Account, if you’re a nerd.  There are two types of nerd IRAs- Traditional and Roth.  In 2019 you can contribute up to $6,000 into these accounts.  You can split the money however you want as long as the total ads up to no more than $6,000.  Follow? Follow.

What’s the Difference Between The Two Nerd Types of IRAs?

A Roth IRA is not tax-deductible, so it’s funded with after tax money. This means you get taxed on your income like normal. You earn $60,000 and the government pick pockets you on all $60,000. Then, you contribute up to $6,000 of whatever meager sums you have left over to your Roth IRA.

The money grows tax-free and you are able to take the principle out, tax and penalty-free. You have to pay taxes and penalties for any of the gains you take out, above and beyond the principle, before age 59 1/2.

There are some fun reasons why you might not be penalized for taking the gains out before you turn 59 1/2 such as if you die.  So if you really want to get that sweet, sweet IRA money tax and penalty free, but you aren’t old enough, you can always die. Silver lining.

A Traditional IRA is before tax, so your contributions are tax deductible.  If you earn $60,000 but contribute $6,000 to your Traditional IRA the government only gets to stick their hands in a pot of $54,000, instead of the entire $60,000. This will save you a couple grand in taxes.

With a Traditional IRA you pay taxes when you take the money out.  But you can’t take it out until age 59 1/2 unless you feel like really getting walloped with penalties, or unless you do a Roth conversion ladder.

If you don’t start taking the money out by age 70 1/2 you could be required to do so, whether you want to or not.  This is called required minimum distributions, or RMDs.

Why Should I bother with an IRA?

IRAs are fun because the gains grow tax free.  In a regular brokerage account you get taxed on whatever money your money makes.  In an IRA you don’t get taxed on the gains.  IRAs are a great vehicle to help build wealth.

Maxing out either your Roth, Traditional, or a combination of both, should be your first goal.

What is the best type of IRA?

I have no idea.  Actually, it’s an India Red Ale.  An India red ale is far superior in flavor and consistency to either a Traditional or Roth IRA.  It’s not as hoppy as an IPA and is generally richer.  Also it contains alcohol.

As far as Traditional vs. Roth, It depends what you want to do. In the grand scheme of things you’ll have more money if you go with Traditional IRA rather than Roth IRA.  The downside is you have less access to that money.

If you’re planning on retiring early the best course of action is to have enough money in after-tax accounts to last you for five years.  This can be in either brokerage accounts or your Roth IRA.  The rest you should put in Traditional IRA.

Why Five Years?

You want enough money in your after-tax accounts to last five years because you’ll be doing a Roth conversion ladder.  A Roth conversion ladder basically means you put money into a Traditional IRA then once you retire you convert a little each year from your Traditional IRA pot and move it into your Roth IRA pot.

This is a taxable event. But, because you’re retired, you’re not earning very much income. Therefore, you’re taxed at a much lower bracket than you would be if you took the tax hit now.

The money has to sit in the Roth IRA for at least 5 years before you can spend it, so once you reach the sixth year of retirement you can start spending the money that you converted during your first year. Then, in the seventh year you spend the money you converted during your second year of retirement and so forth.

This effectively means you end up paying little to no taxes on it going in or going out.  This is what we should all do.  That there is known as the Roth conversion ladder, made famous by The MadFientist.

Side Note:  If you haven't read The MadFientist blog I don't know why you're reading this blog.  If that blog was the Golden State Warriors this blog is the fat 11-year-old kid down the street who wears those trash talking Nike shirts that say things like "Dunk. All. Day" or some such thing.  

That blog is like an Imperial Stout fancy beer compared to the Kirkland Light which is this blog.  

That blog is like grass fortified with Scott's turf builder, this blog is like that yard at the end of town that finally gets mowed after old man Lowery dies and it turns out there was a car underneath all that grass.   I feel I've made my counter-productive point.

Wait, what?

Great question.  So, if you retire early your tax bracket will theoretically be lower later, when you’re not working, than it is now, during your working career.  This is the opposite of most people who have their peak earnings later in life.

When you convert money from Traditional IRA to Roth IRA you will be taxed on this money as income so you want to wait until you aren’t earning any other income (or as little as possible) so that you get taxed at a much lower bracket.

In 2019 for a married couple the tax rate is only 10% if you earn between $0 and $19,400 plus you get to add in the standard deduction of $24,400 which means you can earn up to $43,800 and still only be in the 10% tax bracket federally.  Sweet, huh?  If you accidentally have a couple kids you get to add even more of a deduction.

In a Nutshell

If you’re doing the traditional career path where you think you’ll earn a much higher salary later in life, then you should invest in Roth IRA now.  The reason for this is you’re currently in a lower tax bracket than you will be later.

If you plan on retiring early, cutting back to part-time, or for any other reason earning less later, then you should invest in Traditional, because you’re earning more now than you likely will be later on in life.

Anyway, I hope that really clears up some confusion about IRAs and what type you should get.  I’m not an accountant, or even good at personal finance, so for sure don’t take my advice without doing some more actual research.

Hugs and kisses,

Mr. Burrito Bowl

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Here’s a few more articles where I basically say the same thing:

Save Pretax- Becoming a Millionaire and Achieving Financial Independence

If You Just Save a Little Bit, It’s Not Really Worth it. Ya Know?

Financial Independence- The Freedom to Choose