Two methods of investing in the stock market enter the ring.
Only one will leave victorious.
Welcome back to another installment of… INVESTING DEATHMATCH!!!!!!!!!
If you’re one of our Patreon supporters, there are four things I know for sure about you. One: you’re beautiful on the inside and out. Two: you’re powerful, also on the inside and out (like, you are spiritually intimidating and also extremely muscular). Three: You have excellent taste in blogs run by women who are emotionally in their mid-seventies but physically in their early thirties.
The fourth and most important thing I know about our Patreon supporters is that once a month, they get to choose a topic for an upcoming blog post. And this month they selected a battle royale between traditional IRAs and Roth IRAs.
So if you enjoy this week’s post, you have our gorgeous, strong, good-taste-having, democratically-empowered Patreon supporters to thank for it. Please consider becoming one, or continue to aspire to grow up to be one.
Now let’s get down to the EXTREMELY ANALYTICAL CARNAGE.
The reigning champion: traditional IRA
An Individual Retirement Account is a type of savings account. Just like your regular old savings account, you put money into it, and you can take it out again later when you need it, hopefully with some sprinkles on top. But unlike an all-purpose savings account, an IRA is specially designed to hold money for one’s future retirement.
Unlike an all-purpose savings account, an IRA is specially designed to hold money for one’s future retirement.
Why do we need these specialized accounts? Well, Uncle Sam really wants to incentivize people to save up for their retirement, because millions of dead-broke elderly people are a bit of a liability. And even though saving for your twilight years is a really, really, really good idea, it’s hard to get people to do it. It’s probably because we keep inventing things like water trampolines. I’m on hold to buy six right now, and I don’t even live on or near the water! And yes, I buy things on the phone! (See aforementioned emotional maturity of the average septuagenarian.)
So this IRA is designed with incentives that make it easy to put your money in, but hard to take it out for any purpose other than retiring, and specifically retiring in old age.
You can access the money in your IRA for non-retirement purposes, but there are heavy tax penalties for doing so too early—at least 10%. It’s best to think of the money as Selina Kyle in The Dark Knight Rises. She’ll show up at the last possible second to save your ass by shooting Bane with a Batpod cannon, but she does everything on her own terms, so you still can’t rely on her, per se.
The reigning champion of IRAs is the traditional. The most notable feature of the traditional IRA is that your money is taxed coming out, not going in. Meaning if you make $50K a year and put $3K into your traditional IRA, you will not pay income tax on that $3K until you are An Old and ready to take the money back out. Then and only then do you pay the income tax.
The upstart challenger: Roth IRA
Roth IRAs are named after Samantha Roth, the fiery red-haired Scottish detective who, in 1971, finally caught the infamous serial killer Bible John as he preyed upon unsuspecting women at Glasgow’s Barrowland Ballroom.
THE FACTS ARE THE FACTS, PEOPLE.
Okay, okay, it’s named after one of the legislators who came up with the idea. But my Samantha Roth fan fiction will be available soon as a bonus for our Patreon supporters.
The Roth IRA is basically the inverse opposite of the traditional IRA—the money is taxed on its way in rather than on its way out. There are other differences but overall they’re minor tweaks that facilitate this key difference. If you’re interested in the minor intricacies between the two, Nerd Wallet has a really nice table that breaks down the minor apples-to-apples comparisons.
And the winner is…
Okay, okay, I’m sorry, I’ll extrapolate!
The Roth is almost always the right choice for young people and low-income people, because they are more likely to be in lower tax brackets. If you diligently save a healthy portion of your income in your Roth retirement account, by the time you are ready to withdraw it, you’ll likely be in a higher bracket than you were when you first paid your taxes. But you’ve already ponied up at the lower rate, allowing you to walk away whistling like a trickster Looney Tunes character.
Some people will say that a Roth IRA is always the winner in this fight, and that’s not the case. There are situations where a traditional account would be better. It’s just that those situations are rarer.
Most people earn more money at the end of their lives than the beginning. Older individuals are theoretically at the top of their careers and earning more than their counterparts still in their twenties. They have more investments and may own real estate.
But if you’re interested in retiring much earlier than most (i.e. FIRE), traditional accounts could actually be better. If your life plan includes your income tapering off—like, say, if you have a plan to switch to part-time work after age whatever—you may want to pursue the traditional model. Your tax bracket would be lower at the end of your life than at the beginning.
But again, this is rare. For the majority of people, the Roth is the better option.
I personally would probably benefit from a traditional account, yet I have a Roth. I like the cleanliness of it. If I follow all the rules, I know that 100% of the money sitting in my IRA account is mine upon retirement. I don’t have to calculate what it will be minus taxes, which makes it easier to figure out how close I am to meeting my savings goals. I’m learning to live with less now by accustoming myself to paying taxes on money I don’t yet have. And I don’t have plans for a dead halt to my earnings, even after I retire.
The rule of thumb is this: if you think your tax rate will be higher when you retire, choose a Roth IRA so you can pay taxes now when you’re in a lower bracket. If you think your tax rate will be lower when you retire, choose a traditional IRA so you can pay at a lower rate later.
Another way to put it: Roth is usually the better choice for young people far away from retirement, and traditional is usually the better choice for middle-aged or older people close to retirement.
If you’re really not sure, go with the Roth. Overall it is the better choice for most people—and most people are most people. And in the minor non-tax variations between the two plans, the Roth offers a bit more flexibility in terms of age of withdrawals, minimum withdrawals, and conversions.
The ultimate victor
Investing in your retirement in any way is the real winner!
The type of account where you store your retirement account definitely matters. But this is the kind of choice that can paralyze or confuse people into inaction. And taking no steps, or egregiously delayed steps, is the worst possible outcome when saving for retirement.
And if you have an old traditional IRA with $700 in it from the Aeropostale whose shirts you folded all throughout high school, you don’t have to rush out and mess with it now. Putting extra money into your student loans or credit card debt is almost certainly a better investment.
Thank you again to our Patreon supporters for sponsoring this milquetoast smackdown! We hope all of your contributions are MAXED OUT and READY FOR THE PUMMELING that is life in a capitalist world.