Become a better investor
Lesson in Course: Finance at work (advanced, 8min )
Retirement accounts provide tax benefits. What does a taffy-like candy have to do with retirement accounts?
Now and Later is a bold fruit-flavored candy that first made it onto the candy scene back in the 1960s. The name suggests we'll like them now and then want some more later.
We've learned about IRAs, retirement accounts through work, their limits, and their benefits for long-term investing. However, retirement accounts come in two flavors, Traditional and Roth. The difference between the two primarily comes down to the tax treatment of our contributions.
With Traditional retirement accounts, we receive our tax benefits now.
Contributions to Traditional retirement accounts are tax-deductible, which lowers our income taxes today. We defer the taxes, and eventually, we will pay them when we withdraw that money in retirement.
These accounts are a good choice if we expect our income tax rate will be higher today than in retirement—this is usually the case.
With Roth retirement accounts, we receive our tax benefits later.
Contributions to Roth retirement accounts require us to pay taxes now, but we won't have to pay income taxes when we withdraw that money in retirement.
Roth retirement accounts are situational and better suited for investing in riskier assets. If these riskier assets pay off, we won't have to pay any tax on the significant gains!
To fully appreciate the potential of a Roth IRA, let's say we bought only Tesla stock with our contribution. On 12/21/2015, we could have contributed $5,500 and bought 118 shares of Tesla's stock priced at $46.51 to sit in our account.
Five years later, on 12/18/2020, this risky investment became worth $82,010 with shares valued at $695.00 per share!!
As long as we wait until retirement, we can withdraw the $5,500 contribution AND the $76,510 gain completely tax-free.
If we did this in a Traditional account, the $82,010 would be subject to income tax when withdrawn in retirement, paying anywhere from 20% to 35%. That is roughly $16,400 to $28,700 out the door instead of staying in our pocket.
We can have both account options set up. Just like our sweet treat, we can enjoy some of the tax benefits now and later. We could prioritize our contributions to our employer-sponsored plan, like a Traditional 401(k), and then invest more for retirement in a Roth IRA.
The 401(k) contributions allow us to benefit from deferring income taxes today while putting money in a Roth IRA enables us to invest more aggressively to take advantage of tax-free growth.
The video below provides more depth on the difference between Traditional and Roth IRA accounts:
Here is an article about how the ultra-rich have been using Roth IRAs:
If possible, we can maximize our retirement savings by contributing to both Traditional and Roth retirement accounts. Contributions to Traditional accounts help us lower our tax bill today, and Roth accounts for high growth and tax-free money later.
Individual retirement accounts in which contributions can be deducted from our income taxes. The account grows tax-free; however, income taxes are owed when money is withdrawn in retirement.
Individual retirement accounts in which contributions are made with our after-tax income. The account grows tax-free and no taxes are owed when money is withdrawn in retirement.