Traditional IRA, Roth IRA, Thrift Savings Plan (TSP), Roth TSP, 401(k), Roth 401(k), 403(b), and Roth 403(b) accounts are the main types of retirement accounts for those that are not self-employed. The different options can at times be confusing and overwhelming. Today, I’ll go over Roth IRAs and explain why Roth IRAs are the most powerful retirement accounts.
Roth IRA vs Traditional IRA
First, an IRA is an Individual Retirement Arrangement. The two primary types IRAs are traditional IRAs and Roth IRAs. There are a few basic differences between traditional IRAs and Roth IRAs. Look at the table below for a comparison.
| Roth IRA | Traditional IRA | |
| Taxes on Contributions | After-tax | Pre-tax or After-tax |
| Growth | Tax-free | Tax-deferred |
| Max 2020 Contribution | $6,000 ($7,000 if over 50 years old) | $6,000 ($7,000 if over 50 years old) |
| Contribution Eligibility | Depends on Income (click here for 2020 income limits) | Anyone |
| Required Minimum Distributions (RMDs) | None | After 72 years old. |
| Taxes on Withdrawals | None | Taxed as Ordinary Income |
The major negative for Roth IRAs is that you must pay taxes when you make contributions. The major positive for Roth IRAs is that you do pay taxes when you contribute and do not pay taxes on any withdrawals, no matter how much your Roth IRA grows. The other major positive is of Roth IRAs is that there are no Required Minimum Distributions (RMDs), which means that once you’ve reached the age where you can withdraw penalty free (59 ½ years old and the Roth IRA account is over five years old), you can withdraw the money on your terms and not be forced to make RMDs after you turn 72 years old. RMDs are required for all of the other retirement accounts listed at the beginning of this post. RMDs serve the purpose of making sure Uncle Sam gets his cut on his terms.
Tax Treatment
Traditional IRAs, as well as all other pre-tax retirement accounts, are taxed as regular income when you take withdrawals. There is an additional 10% penalty for withdrawals before you turn 59 ½ years old. Below are two tables. The first shows full contributions ($6,000) from 38 years old until 60 years old, and also shows the taxes you would pay if you’re contributing to a Roth IRA and are in the 22% tax bracket. The second table shows Required Minimum Distributions starting at the age of 73 (the year after you turn 72) and going until you are 82 years old (10 years of RMDs).
Table 1 shows $6,000 annual distributions for a 38 year old from this year (2020), until they turn 60 in 2042. It assumes a 7% growth rate until the end of 2054, the year the IRA owner turns 72. It also shows the amount of income taxes that would be paid ($38,916)if these contributions were made to a Roth IRA, and the contributor was in the 22% tax bracket.
Table 2 shows 10 years of RMDs if the contributor contributed to a traditional IRA instead of a Roth IRA. It also shows the minimum taxes a person would pay when they took RMDs, and assumes a 5% growth rate. After 10 years, $40,323 income taxes would be paid on the RMDs.
As you can see, you’d pay $38,916 in taxes if you made 23 years of contributions to a Roth IRA, but you wouldn’t pay any taxes on the withdrawals during retirement. If you instead invested in a traditional IRA, your RMDs would cause you to pay $40,323 during your first 10 years of withdrawals. And those taxes are only for RMDs. Any additional money withdrawn above your RMD in a given year would incur additional income taxes. Click here to see how RMDs are calculated or here for a RMD online calculator.
Rollovers
After you leave an employer or retire, you will be able to move your retirement account to another retirement account if you would like. For example, once you separate or retire from the military or corporate world, you could roll a Roth TSP or Roth 401(k) right into a Roth IRA. All it should take is filling out some paperwork (like this ‘External Transfer Form’) and sending it in (digitally or electronically) to the company where your Roth IRA is. It is a one-time action that will give you more control over your money during your retirement years. And once your Roth TSP or Roth 401(k) are rolled into your Roth IRA, you will not have to make RMDs once you reach 72 years old. Again, this gives you more control of your retirement funds.
Backdoor Roth IRAs
If you don’t qualify to contribute to a Roth IRA, you could try to contribute to a Roth IRA via a Backdoor Roth IRA. I’m not very familiar with them, and would highly recommend getting assistance from a tax or finance professional before executing a Backdoor Roth IRA.
Wrapping up
There are a lot of ways to save for retirement, but I hope this post helped clear up why Roth retirement accounts, especially Roth IRAs, are very advantageous in giving you more control of your money in retirement. If you’re planning on making it a career in the military, make sure you look for my next post. I’ll be breaking down the numbers even more to show why a Roth IRA and Roth TSP should be your choices for contributing to retirement over a traditional IRA and Traditional TSP.
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