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Roth IRAs

Introduction to Roth IRA's. Created by Sal Khan.

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  • spunky sam blue style avatar for user jarekb
    I'm a bit confused on why $3,400 was the amount contributed toward the roth ira. Couldn't you fund it with the full $5,000 then at the end of the year pay the extra $1600 in taxes while your account is funded with the 5k plus your earnings?
    (12 votes)
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    • male robot hal style avatar for user johnsalyers
      In his example though, he assumed you only had $5,000 to set aside for retirement when you opened the account. If you didn't have that extra $1600 to set aside, then you couldn't very well put it into an IRA, could you?

      That is just another advantage of a Roth IRA that he alluded to but didn't actually spell out. Every situation is a little bit different so it's a good idea to really think about your personal situation and pick the right option for you.
      (19 votes)
  • orange juice squid orange style avatar for user ṈÎnja34 (Check out GEM Quest!)
    I don't understand the point of Roth IRA's, why not just use Traditional IRA's?
    (6 votes)
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    • old spice man green style avatar for user Alf Lyle
      Basically, with a Roth IRA you are betting that the tax rate you'll be paying when you withdraw the money will be higher than your current income tax rate and you are making the opposite bet with a traditional IRA.

      For example, suppose you are at the beginning of your career and only being taxed at a 2% rate and you expect to be in a 30% tax bracket when you start to withdraw your IRA money. (You made some great investments during your illustrious career, say.) You get almost no savings in this case if you put your money into a tax deferred (Traditional) IRA since you are barely paying any income tax anyway, but will be real happy to be paying 0% tax on the money as you withdraw it instead of 30%.

      Does that help?
      (22 votes)
  • blobby green style avatar for user galkhalidi
    Weren't the calculation done wrong? When we double the $3,400.00 He should've put $6,800,00 not $7,800.00 which at the end, would result to $13,600.00 for the Roth IRA.
    (11 votes)
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  • leafers tree style avatar for user erikepp
    At in the video, when he doubles the $3400 in the Roth IRA, shouldn't it be to $6800, which later on makes only $13600 available at retirement (doubled again)? Doesn't this change the outcome, making the Roth less advantageous (aside from flexibility)?
    (2 votes)
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    • orange juice squid orange style avatar for user Ctrader621
      There is a blue bubble that pops up briefly at 14.48 with a correction. The correct amount with the taxes used in this example is $13,600. The basic idea is still that if your taxes are the same now as in retirement, the plans are equal except for added flexibility on the Roth. If your taxes will be higher in retirement due to loss of deductions or whatever, Roth is better for you. If you expect your taxes to be lower in retirement then Traditional might be better for you. Of course if you know what the tax rates are going to be in 20-30 years you are probably smart enough to not need to worry about this stuff. I'll be using a Roth.
      (12 votes)
  • male robot donald style avatar for user A. DeBo
    Is it possible to have multiple IRA's, and if so can you have both a traditional and roth IRA? If it is possible what are the restrictions or limitations.
    (5 votes)
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    • leaf green style avatar for user Michael
      You can have more than one IRA, in fact you can have more than one type of IRA. You could potentially have a traditional IRA as well as ROTH IRA(s). Remember that there are restrictions on how much you can contribute to your traditional IRA as well as your Roth IRA. It is possible to have multiple traditional IRAs as well as multiple Roth IRAs. The only restriction on the number of IRAs that a person can have is limited only by the dollar amount you have in the IRA accounts and the minimums that the institution that you are working with may impose.

      If you need more free help email me at mspeer@speerwealth.com.
      (7 votes)
  • blobby green style avatar for user aaroncelser
    As an american working abroad and not making any domestic income, is it possible for me to invest in a Roth without incurring any penalties? I can't seem to get a straight answer from anybody.
    (5 votes)
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    • leaf green style avatar for user Nathan
      I would certainly be careful with it. Recall that in 2006 the HERO Act was passed to permit soldiers serving overseas to include their non-taxable combat pay as gross income for IRA contribution purposes. Generally speaking, any foreign earned income up to the "foreign earned income exclusion" limit (and the foreign housing deduction if eligible) is not considered compensation for IRA purposes.

      Page 8 of the 2012 IRS Publication 590 under "What is not compensation?"
      http://www.irs.gov/pub/irs-pdf/p590.pdf
      (5 votes)
  • spunky sam blue style avatar for user Cogito, ergo sum
    If someone has a Roth IRA and they never withdraw the money and just pass it on to their children, do the children have to pay taxes on it when they withdraw the money?
    (4 votes)
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    • leaf green style avatar for user Nathan
      Generally no but situations can arise when taxes are owed on Roth IRA distributions. The taxability of Roth IRA distributions is determined by the "type" of money coming out of account. Consider 3 types of money: Roth contributions, Roth conversions, and earnings (gains).

      As Roth IRA contributions are not tax deductible, they can be withdrawn for any reason at any age tax and penalty free. Any money that has been converted from a traditional IRA (or 401k, profit sharing plan, any other eligible plan) to a Roth IRA is taxed in the year of conversion so it will not be taxed again when it is withdrawn. The last type of money, the earnings, are only taxable if withdrawn within 5 years of the year for which the initial contribution was made. If you make your first Roth contribution in March 2014 for the 2013 calendar year, the 5 year clock starts ticking on January 1, 2013 (not a typo!)

      The 3 types of money are withdrawn in the following order: 1.) contributions 2.) conversions on first-in first-out basis 3.) earnings. These ordering rules only apply to Roth IRA distributions where the 5 year clock has not been reached. Once the 5 year period passes all distributions for the children would be tax and penalty free.

      To sum everything up, as long as your initial Roth contribution is made 5 or more years before the children withdraw earnings (keep in mind this is after all the contributions/conversion as well as the account holder passing) they will not have a tax liability.

      Pages 69-72 of IRS Publication 590 may be helpful.
      http://www.irs.gov/pub/irs-pdf/p590.pdf
      (4 votes)
  • leaf grey style avatar for user Death the Kid
    So, the Roth IRA would most likely be a better choice, correct?
    (4 votes)
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    • piceratops tree style avatar for user Julie Frakes Gattenio
      From what I can tell, yes, Roth is most likely the better choice. The most important factor is that Roth has no tax on gains. The strength of long-term investments is in the gains made during the life of those investments.

      Typically speaking, a smaller investment amount with a higher rate of return will do better than a larger investment amount with a lower rate of return.
      (Traditional: contribute before tax, so "larger investment amount," but tax on gains, so "lower rate of return."
      Roth: contribute after tax, so "smaller investment amount," but no tax on gains, so "higher rate of return.")
      (3 votes)
  • piceratops tree style avatar for user 213alk
    What's the point of Roth IRAs when you are taxed and you are just putting your money aside for later. Can't you do the same thing with a savings account?
    (2 votes)
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  • leaf green style avatar for user FinallyGoodAtMath
    Why are all the taxes at the income tax rate and not the capital gains rate?
    (5 votes)
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Video transcript

What I want to do in this video is to give you the gist of what the Roth IRA is all about. Just to get an idea of why it's called the Roth IRA, it's named after William Roth, the late senator from Delaware. He helped, I guess, you could say shepherd this legislation in 1997 when it was first passed so they named the IRA after him. William Roth from Delaware. That's where the word comes from. It's a special type of individual retirement account. Why did they go to the trouble of creating a new one? Let's think about what a traditional IRA does and then I'll talk about why a Roth IRA could be interesting or it's a little bit different or what could be beneficial and then we'll actually see it in an example. The first question is what happens when you put money into a traditional or a Roth IRA? In the traditional IRA video you saw that it's tax deferred. That if you were to put $5,000 in your traditional IRA you are not taxed on that money. In the Roth IRA it is not deferred so you would actually pay taxes on that $5,000. Immediately you're saying,"Hey gee. "This doesn't seem like that great of a thing. "Why would I ever use it? "I have to pay taxes on the money I've put in." This is the interesting thing. In both situations, as long as your investments stay in either traditional or Roth accounts earnings are not taxed while in account. This is true for both of them. But you're still going to say, "Hey Sal. "The traditional still looks a lot better. "I had to pay taxes on the Roth right from the get-go. "I didn't have to pay it on the traditional. "Then they can both grow "and I can buy and sell my stocks "or invest in mutual funds "or whatever I do inside of them. "I don't pay taxes. "The traditional still looks better." Now, the interesting thing is what happens when you withdraw the money? There's a lot of special circumstances on when a withdrawal is qualified or not. I'm not going to know the details I really just want to give you the essence of why the Roth is interesting. Let's say you're over 59-1/2 years old and in the Roth. Your money has been there for more than 5 years, it's been seasoned. I'm not going to go into all of the particulars. The traditional IRA when you withdraw, let's say we're older than 59-1/2 for both and then we do a withdrawal. In the traditional IRA you have to pay taxes. You pay taxes, you're taxed. Ordinary income tax. While in the Roth IRA no taxes. Not taxed. We saw in the traditional IRA video that this has to be pretty good when you're older than 59-1/2. You might be retired. You might be in a lower tax bracket. You're going to pay lower taxes on it and it's been deferred for however many years your IRA has been in existence. This is especially interesting because over here you paid tax just on the original amount that you've put in and then you'll allow that original amount to grow over many, many, many years and then all of a sudden you're not taxed at all. That, all of a sudden, becomes a little bit interesting. This seems like a pretty good thing to have. We're going to actually play with the numbers to see how they workout. Now, the other interesting thing about the Roth is if you early withdrawal. For a traditional IRA you pay 10% penalty on the withdrawal plus you get taxed. Plus taxes. On the Roth IRA if you're just taking the original amount you've put in and I'll do this with a numerical example. If you're just taking out your principal amount no taxes or penalty on the principal. No taxes or penalty on principal. And you would only have to pay even if it's a non-qualified withdrawal. There's all these special circumstances, what's qualified and I'm not going to go to the details. You would only have to pay the 10% penalty and taxes on earnings. One of the main reasons why I'm not going in all the details is one: It would make the video a little confusing, but also, the government is constantly changing the details. I want you to be able to watch this video as many years in the future and not to be dated so I don't want to go into all of the different things that the government is changing from year to year. Let's just do a very basic example just to get the sense of things. Let's look at at a traditional IRA and then we have a Roth. Let me write IRA just to be clear that we're talking about an IRA in both circumstances. Let's say my original income amount, let's say I've made more than $5,000. I'll just use $5,000 as my example and I'll also make another note. Roth IRA is subject to more limitations in terms of your total overall income and that's also changing. I don't want to be specific on the numbers. You could look that up. There are ways that you can transfer traditional IRAs into Roth IRAs. That's a little bit of a loophole on being able to get around some of those restrictions. But anyway, I won't go into the details just yet. Just remember, Roth IRA, there are some more limitations on whether or not you can put things into it. If you're tricky you might be able to get around them. Let's say you have $5,000. And just so you know, the limits on IRA is they apply to Roth or traditional or any combination of the two. If you're starting with $5,000, so in the traditional IRA you have 0 taxes initially. In your Roth IRA initially, let's say you have a 32% tax bracket just like in the previous video. 32% of tax bracket. Then you'll pay 32% on $5,000, 32% on $5,000. That's .32 x $5,000. That's $1,600. You're going to pay $1,600 in taxes. Your amount in the account, in your account, your principal, in your traditional IRA and maybe I should write it out here. Starting with that $5,000 your principal is going to be $5,000 here. You have to take 1,600 out for taxes so it's only going to be $3,400 right there. Let's say in either situation you were to take that, invest it in some stocks and then 5 years later it doubles. Let's say at some future point it doubles and you sell those stocks. That becomes $10,000 in your account there and then this, you invest it in stocks and it doubles. This becomes $7,800 in your account right here. This is 5 years into the future. I'm just picking that into the future. Let's say we're still not 59-1/2 years old just yet. Now, we could just continue to leave either of these amounts in our account until we're 59-1/2. Let's say we have some type of need, we need to give a loan to our brother-in-law or something. We really want to have access to this money. Let's look at the situation where we withdraw. If we were to withdraw, let's think of a couple of situations. If we were to withdraw $3,400. Let's say that exactly what my brother-in-law needs just right now. If we were to withdraw $3,400 in the traditional IRA sense, in the traditional IRA case. We take out $3,400. We're going to have to do 2 things: First, we're going to have to pay taxes on it. We're going to have to pay 32% of that assuming we're still in the same tax bracket. $3,400 x .32 is equal to, we're going to have pay $1,088 in taxes. We're going to have to pay $1,088 in taxes. We're also going to have to pay a penalty on this entire amount, on the $3,400. We're also going to have to pay 10% penalty, $340 penalty. We're going to be left with after paying all of these, let me get the calculator out and let's see, the calculator right there. We're going to be left with 3,400 - 1,088 - $340 = $1,972. We're left with $1,972. In the Roth IRA, when you needed that money all of a sudden and you decided to withdraw it early and we're only taking out $3,400. We're taking the amount that was our original principal. In the Roth IRA we get the $3,400 because that was our original amount and we pay no taxes or penalties. At any point in time on the Roth IRA you can always take your principal out. In the other types of IRAs not only will you have to pay taxes on it, you're also going to have to pay a penalty on top of that. The Roth IRA, one of the very positive things is it gives you a lot of flexibility. Now, let's say you needed to withdraw, I don't know, let's say you needed to withdraw $4,000. This is another scenario, $4,000 at this same point in time. Within the traditional IRA scenario, once again, you're going to have to pay 32% of that in taxes. You're going to have to pay 4,000 x 32% in taxes and you're also going to have to pay + $400 penalty. In the Roth IRA case, you pay nothing. You get the original principal you have put in, that was your original amount, $3,400. In all of this, I'm assuming that we're not 59-1/2 years old just yet. In the Roth situation, you get the $3,400 free and clear, tax and penalty free. But the other $600, you're going to have to pay 32% taxes or whatever your tax bracket is and then you're also going to have to pay $60, a 10% penalty on just the earnings portion. Remember, 3,400 was your principal, then if you want to take 4,000 out, the 600 extra, that stuff that you earned. That stuff that was grown from the principal. You're going to have to pay plus another $60 penalty. But it's still a much better situation if you do the math than this one here. In general, if you think, if you're not sure whether you're going to need that money before you retire, the Roth gives you a lot more flexibility. Now, let's go all the way to retirement. Let's go all the way to retirement. Let's say we didn't ever withdrew any money. We invest it in another stock and so we go 10 years later. We never withdrew any money. We're just going to look at the retirement situation. We go to our stock and we sell it, our new stock. We get the 20,00 there, here we get $15,600. Of course, in both of these situations its great that we're able to buy and sell stocks inside of these retirement accounts and not pay taxes. If these were not sitting in retirement accounts every time we bought and sold the stocks we would have to pay capital gains tax and you saw that in the previous video. Now, now that we are over, let's say we're 60 years old. We can now withdraw our money from either situation. There's some other stipulations, your money has to be seized and has to be sitting there for 5 years and all but I won't go into the details. Let's see what happens when we withdraw the money. Let's say we have a 25% tax bracket now. 25% tax bracket. We're retiree, we're earning a little bit less money, we are in a lower tax bracket. In this situation we're going to pay, when we withdraw it from a traditional IRA we are going to pay 25% in taxes which is $5,000 in taxes and we are going to be left with $15,000 for ourselves to spend in our retirement years. In the Roth IRA situation, once we're over 60 years old our tax bracket doesn't matter. We just get the money, $15,600 free and clear. If you think about it in either situation, when we withdrew early, the Roth IRA was much more forgiving especially if we withdraw less than the amount that we originally put in, $3,400. The Roth IRA does not tax us or give us penalties. It only does that on any money that we earned, any money in excess of the $3,400. The traditional IRA taxes us and penalizes us on everything. Even when we go into the future, remember, in the traditional IRA we didn't pay any taxes to begin with but we had to pay taxes to end with. When we paid taxes in the end, we're paying taxes not just on what we've put in initially we're also paying taxes on all of our cumulative earnings, right? We originally put in 5,000, now we're paying taxes on 20,000. We're going to only end up with $15,000 while in the Roth IRA we don't pay taxes on anything. In return for being willing to pay our taxes front loaded to pay them in the beginning, we'll never have to pay taxes on that money or on any of the earnings that that money makes. Now, I fixed the numbers here to make them close. Depending on your tax bracket before and after or how much growth you actually see in your earnings, one maybe better than the other. But these are important considerations. I just want to let you know the pros and cons. The Roth IRA tends to be better in terms of giving you this flexibility and not worrying to pay taxes at the end. There's one other thing, this is depending on how you view life, it might be a minor thing. In the traditional IRA, when you're 70-1/2 they force withdrawal and then of course you have to start paying taxes on things. In a Roth IRA, there's no age limit. That's another consideration you might want to take into.