What is an IRA and how do I pick between a Traditional vs. Roth? (Part 2)
Written By: Nick Nguyen | Read full profile
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Okay, so back to that birthday party scenario. My friend is making around $50,000 in her day job. Which one would be best for her, traditional IRA or roth IRA?
Well that depends on a few factors:
Remember, the biggest reason why your wealth doesn’t grow as fast as you’d think it would is because of taxes. I mean, taxes do serve a purpose, and for the most part, they do fund a lot of great programs in society. They could be better managed - but that’s a story for another time. What I’m talking about here is how she’s filing taxes for that current year. Because she’s making $50,000, about $10,000 will be taxed at 22%. That means that out of the $10,000 that is in the next income bracket, $10,000 x 0.22 = $2,200 dollars is gone out the window. One benefit of the Traditional IRA is that you can deduct the amount you contribute from your overall income. In a sense, that would mean that you could ‘prevent’ the IRS from collecting $2,200 at this point in time. This could be great because you’ve lowered your effective taxable income for that filing year and put it inside an investment vehicle where it can compound and grow over time!
+1 for the Traditional IRA here.
Let’s say she’s a savvy investor and knows how to make deals that can give her better returns than the current stock market. For example, if she could use that $10,000 to buy a piece of real estate and get a 22% or more return on her money, then the decision to do a Traditional IRA is moot. She could just get that bigger return and contribute it to a Roth. Now this is just one example of a missed opportunity cost that could happen if you were to deposit a large lump-sum of money into a Traditional IRA. As a young real estate investor, I know that your earning potentials are endless if you can find the right deals.
I’m giving her credit that she doesn’t live like most yuppies who spend all their money on looks and materialistic pleasures. Assuming you don’t have any debt, you could be saving quite a decent chunk of your income each year to fund your emergency fund. But let’s be honest, I’ve come to the shocking realization that a lot of very smart people still have small debts in credit cards, car loans, and the dreaded student loan. So maybe your cash flow isn’t as great as it could be, and you just blew your last emergency fund on that ‘I can’t miss this’ trip to Fiji with your friends. This is where picking a Roth IRA might be the better way to go. Since your contributions are already taxed, you can withdraw them at any time without penalty. And if you read my post about opening your Roth IRA early with $1, you might be close if not already finished with that 5-year holding period so that you can withdraw earnings for qualified withdrawals. Either way, Roth IRAs are great emergency funds that can be used in case your car breaks down or if you’re buying your first home that was a deal that’s just way too good to pass up.
Moral of the story: be realistic. Know your personal financial situation and do some quick math or contact a financial planner or tax specialist to help you make an informed decision.
At the end of the day, if you do choose to go with a Traditional IRA, know that you can always do a fancy thing called a Roth Conversion or ‘Backdoor Roth’, so you’re never really “locked in” to what you choose, but we’ll talk about that later on down the line.
Keep reading in Part 3 for a streamlined decision-tree to see if you even qualify for Roth.
*Nguyening Lifestyles is not a registered financial service provider and does not give financial advice. All information in these posts are for entertainment purposes only. Nguyening Lifestyles is not liable for any actions or outcomes that transpired after your reading of the following post.
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