No difference between a Regular IRA and a Roth IRA?
To be clear, there are differences between a Roth IRA and a regular IRA. More on that later. This section is about the lack of difference between a Roth IRA and a regular IRA with respect to the tax-free withdrawals from a Roth that most people focus on.
Many people are surprised to know that the amount you withdraw from a Roth IRA is the same as the amount you withdraw from a regular IRA if the starting and ending income tax brackets are the same.
I will illustrate this with a simple example. Assume the following:
Current age: 30
Current marginal tax bracket: 20%
Age when you will withdraw funds from your IRA: 60
Marginal tax bracket at 60 (30 years from now): 20%
Amount available to invest in a regular or Traditional IRA: $5000
Expected rate of return for the next 30 years: 7% per annum
We assume that you are within the salary limit for Roth IRA eligibility. We also assume that you are eligible to get a tax break on the regular IRA contribution.
Notice that the starting and ending tax brackets in our example are the same - at 20%.
You started with $5000 in your regular IRA. You can use the full $5000 in your calculations since you do not pay any taxes today on investments in your regular IRA.
If we are doing calculations for a Roth IRA, we would assume you started with $4000. This is because you had $5000, you paid 20% income tax on that amount, and you are left with a post-tax amount of $4000 to invest in your Roth IRA
After 30 years, your Regular IRA would have a balance of $38,061.28. The math is 5000 (1.07)^30
After 30 years, your Roth IRA would have a balance of $30,449.02. The math is 4000 (1.07)^30
Let’s say you decide to take out all the money you had in your regular IRA. You are over age 59.5 and so you will not pay an early withdrawal penalty on any withdrawals from the IRA. But you still have to declare it as income as pay income taxes. So, after paying 20% income taxes on $38,061.28, you would be left with… wait for it - $30,449.02!! This is the exact amount you have available to you in your Roth IRA.
Of course, no one knows what tax bracket they will be in, in retirement. We do not know and cannot predict if there will be significant changes to the tax laws. However, it is safe to assume that you will be paying taxes on your regular IRA withdrawals during retirement and that your will be able to take tax-free withdrawals from your Roth IRA during retirement.
Summer jobs and Roth IRAs
As illustrated in the section above, the net (post tax) distribution taken after age 59.5 is the same for regular IRAs and Roth IRAs if your beginning and ending tax brackets are the same. However, there is a huge difference if the tax brackets are different. What if you could invest in a Roth IRA when you were in a 0% income tax bracket?
This is where parents (or legal guardians) and summer jobs come in. Many teenagers work summer jobs in high school. Even if they are being claimed as dependents on their parent’s or guardian’s income tax return, most teenagers will pay little or no income taxes when they file their returns. Remember – we are talking about $1000 or $2000 of income for the whole year. This is the kind of situation where a Roth IRA would make perfect sense. Low or zero income tax! Plus you are starting early at a young age which means you can get the maximum possible effect of compounding!
Here is a typical scenario:
You are a junior in high[MM1] school and you earned $500 working hard waiting tables at a neighborhood restaurant. This is YOUR money. You earned it. You want to spend your money on going to the bowling alley or to the movies with your friends. The last thing you want to do, is to think about your retirement, which is decades away. Your Dad could tell you about the benefits about opening a Roth IRA till he was blue in the face. You are not interested. But Dad wants you to open a Roth IRA anyway. So, he comes up with a devious plan. He knows you will hate him now but thank him later in life. He says that he was going to give you $125 as a birthday gift. He is willing to double that gift to $250! But that gift now comes with strings attached. You have to open a Roth IRA and invest a matching amount from your summer job earnings into your Roth IRA. In this case, to get the $250 birthday gift from Dad, you would have to invest $250 from your summer job into your very own Roth IRA account.
What should I invest my money in?
Now that you have opened a Roth IRA, what should you invest your money in? There are a million different stocks, mutual funds and exchange traded funds out there. Most people do not have the time or the knowledge or the desire to pick specific stocks or specific industries. They are better off investing the entire amount in a broad-based total market fund with a low or zero expense ratio.
Two such options are the Fidelity® Total Market Index Fund with an expense ratio of 0.015% and the Vanguard Total Stock Market Index Fund with an expense ratio of 0.14%. These are just two options. This is not retirement advice. Please consult your financial advisor if your family has one.
Roth IRAs have another advantage over regular IRAs when it comes to RMDs
Roth IRAs have another advantage over regular IRAs and other IRAs when it comes to Required Minimum Distributions (RMDs). You do not have to take RMDs from your Roth when you reach the age of 70.5. Here is the synopsis, straight from the IRS:
“Your required minimum distribution is the minimum amount you must withdraw from your account each year. You generally have to start taking withdrawals from your IRA, SEP IRA, SIMPLE IRA, or retirement plan account when you reach age 70½. Roth IRAs do not require withdrawals until after the death of the owner.
You can withdraw more than the minimum required amount.
Your withdrawals will be included in your taxable income except for any part that was taxed before (your basis) or that can be received tax-free (such as qualified distributions from designated Roth accounts).”
A note about income and contribution limits for Roth IRAs
There are contribution limits and income limits when it comes to IRAs. These are not fixed amounts and IRS guidelines are updated or changed based on inflation and other factors. For instance, for a person under the age of 50, the contribution limit was $5,500 from 2013 to 2018. It is $6000 for the tax year 2019. But in general, if you make too much money you cannot contribute to a Roth IRA.
You cannot contribute more than your earned income in any year. So, if you earned only $750 this year, the maximum you can contribute is $750. But, hey, every penny counts. Start early and let the magic of compounding work for you.
In this article, we are focusing on high school kids working summer jobs and/or part time jobs after school. There are of course, some kids who start million-dollar businesses as teenagers, but, for the vast majority of kids, the income limit for Roth IRAs can be ignored.
“Anyone with earned income who is younger than 70½ can contribute to a Traditional IRA. Whether the contribution is tax deductible depends on your income and whether you or your spouse (if you’re married) are covered by a retirement plan through your job, such as a 401(K).
Roth IRAs don’t have age restrictions, but they do have income-eligibility restrictions: In 2019, single tax filers, for instance, must have a modified adjusted gross income (MAGI) of less than $137,000 to contribute to a Roth IRA. (Contribution limits are phased out starting with a modified AGI of $122,000—per IRS guidelines.) Married couples filing jointly must have modified AGIs of less than $203,000 in order to contribute to a Roth; contribution limits are phased out starting at $193,000.”
Saving for retirement is never a bad idea. Starting early is an even better idea as it gives you maximum exposure to the magical power of compounding. Combine all this with a Roth IRA where you can make your initial contributions when you are in the 0% income tax bracket, and you have the best possible outcome. Teenagers with earned income are in this sweet spot, and they can be encouraged to start contributing to their Roth IRA with a bit of push from their parents or guardians.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.