Thank you for joining us for Episode 25 of our Money Wisdom Question Series, where we answer common financial and retirement investment questions. Today’s question is, “What are Roth IRAs?”
We get this question a lot and some of you might be thinking, “I know what a Roth IRA is.” Let me explain with an example.
Traditional IRA
I want you to picture a farmer. A farmer buys seeds and then plants and sells the crop at the market, in hopes to make a profit. Let’s say the farmer has a Traditional IRA. The farmer will get a tax deduction when they buy the seeds. If they buy $10,000 worth of seed, they get to deduct that as a business expense. They don’t pay tax and take it off their taxable income. That $10,000 is a business expense and they made an investment.
Then, when they sell the crop and let’s say they sell it for $100,000, they need to pay taxes on the profit. They get a tax deduction on a small amount but have to pay taxes on a big amount when they make a profit on that crop. This is what a Traditional IRA looks like or for most of us our 401(k). We get a tax break when we put the money in, but we have to pay taxes when we take it out.
Roth IRA
A Roth IRA is exactly the opposite of that. What happens in a Roth IRA is when you put the money into the account, you don’t get a tax deduction. Like the farmer, there is no tax deduction to plant that seed. But in the case of the Roth IRA, the parallel is when the farmer sells the crop at a profit, he doesn’t pay any taxes on the profit. He gives up the tax deduction on the front end, but if that Roth becomes much more valuable in the future when we take the money out, it’s tax-free.
Roth IRA Conversions
There are two options:
- Traditional IRA – Have the tax break when you put the money in and pay taxes when you take the money out, which is hopefully a much larger amount.
- Roth IRA – Can forego the tax break when you put the money in and take the money out tax-free.
Some people hear this and think “Oh I wish all of my money was in Roth IRAs.” You can convert a Traditional IRA or a 401(k) into a Roth IRA. For many of you, you should convert. I’ve converted some of my money into a Roth IRA. It means we take that money out of the traditional account, pay taxes on it today, but all the growth in the future is not taxable.
A Roth IRA is a great estate planning technique and for some of you, it might be great for your individual retirement savings. I can’t tell you exactly whether you should do it or not, but you should absolutely have a conversation with an advisor who’s a fiduciary.
If you’re young like my kids, you should put every nickel you have into your Roth. Actually, young people are not watching or reading this, so please communicate this to your kids. Young people should just be putting all their money into a Roth because chances are, taxes are going up.
Thanks for joining me and I hope you found this information helpful!
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