A common misconception I see when interacting with fellow students revolves around retirement accounts. I understand the confusion because, even after majoring in Personal Financial Planning for a year, retirement accounts were still confusing. The hope of this article is to clear up a couple misconceptions and explain the differences between traditional IRAs and Roth IRAs.
Retirement accounts, like Roth IRAs and Traditional IRAs, are not savings accounts with consistent rates of return. Often, when financial planners discuss these accounts and a client’s potential returns, they state the return as a level percentage. For example, during a presentation, the presenter may say the account has an estimated 8% return. This is the assumed average return over the life of the account. The actual daily account balance and percent return will fluctuate depending upon the investments held within the account. This brings me to my second point, IRAs are investment accounts. They hold investments. You do not simply purchase 1,000 shares of a Roth IRA. Let me provide a simplified look at the mechanics of opening and funding one of these accounts. To begin, you open an account with either an in-person financial advisor or online. There are hundreds of different places where you can open an IRA. Second, you would place funds, most likely cash, within the account. Finally, if you should so choose, you can buy different investment securities within the retirement account. The reason I write concerning these issues is my own past confusion. These are accounts are “buckets” that hold the investments.
What’s the Difference?
The investments inside of each account receive different tax treatment because they are sheltered within the account. When you place money inside of a Roth IRA, you are contributing on an after-tax basis, meaning you already paid taxes on the cash going into the account. The benefit comes when you withdraw money from this account. When you make a qualifying distribution from the account, you do not need to pay taxes on the money you originally put in or on the gain made by your investments. Look at this way, if you buy $1,000 worth of stock and it grows to $1,500, when you sell the stock you would ordinarily be required to pay taxes on the $500 in gain. If this stock were sheltered in a Roth account, you would not have to pay any taxes on the gain so long as you made qualifying distributions from the account. You just generated tax free money!
If you place money into a Traditional IRA, you usually are putting in pre-tax money. Money that goes in pre-tax avoids federal income tax until you withdraw the funds. Assume you placed $5,000 of tax-deferred money into a Traditional IRA and it grew to $7,500. When you make a qualifying distribution, you will pay ordinary income tax rates on the whole $7,500. Outside of this tax-deferred account, you would normally have bought stock with after-tax money and, when sold, paid capital gains taxes on any gain made with your investment. Traditional IRAs provide the benefit of helping lower your taxable income today. The other hope is that your income will be lower in retirement, so you pay less taxes on said income.
Are you concerned about your financial future? Consider coming into Powercat Financial where we provide free and confidential advice to all K-State students. If you are ready to more efficiently use your money, schedule an appointment at https://www.k-state.edu/powercatfinancial/. We would love to help you develop healthy financial habits!
Peer Counselor II