Traditional IRA
So you’re here to learn the deal with Traditional IRAs. That can mean only one thing – for some reason, your relationship with a Roth IRA is over. I’m sorry for your loss.
But don’t worry, because now you get to start a new relationship with Traditional IRAs! Like Roth, a Traditional IRA is a retirement account, which is just an account that holds investments that will hopefully grow over time and eventually support you in your retirement.
The Difference
When you contribute to a Traditional IRA, you invest money that you have earned on the books (not paid with cash) before you pay taxes on it.
So if you work at a summer camp and make $1,000 –
- How? I made $350
- You can invest that whole $1,000 in a traditional IRA without paying taxes.
But yes there’s a catch because you can bet the government will get your tax money eventually. The government will just wait until it’s grown into much more money and then, when you retire in a few decades, take taxes on all of the money in your Traditional IRA. This way, the government can tax your contributions (original money you invested) and your gains (what you’re money grew to) over the years and get wayyy more money.
Btw – if you remember, a Roth IRA was CLUTCH because it allows you to invest after-tax money and never pay taxes on it again!
The Perk
But don’t worry! A Traditional IRA has a perk of its own – it’s called tax deductions. Basically, every dollar of income you earn gets taxed with income tax. Income tax is super annoying because it just takes away a whole chunk of money you earned. But here’s the deal – the money you contribute to a Traditional IRA does not count as income to the government, and therefore, you won’t have to pay income tax on it.
If you didn’t fully follow that, just know investing in a Traditional IRA = lower taxes for you.
There you have it. The big perk of a Traditional IRA! Not quite as groundbreaking as a Roth IRA, which is why we recommend ALWAYS investing in your Roth first for as long you are eligible. Keep in mind you get $6,000 (or $7,000 if you’re over 50 yrs old) to invest in an IRA per year, so you have to choose whether to invest it in a Roth or Traditional, or a mix of them. Personally, I’ll be investing that $6,000 in my Roth until I’m not allowed to anymore, but if you really want that tax deduction, go for it!
The Loophole
Maybe you’re sitting here and thinking “shoot, I earn too much to contribute to a Roth IRA, but I really wish I could!” So year after year, you contribute to your Traditional IRA. But wait. Did you know that you can convert a Traditional IRA into a Roth IRA?
Are you ready for this insane loophole?
Here’s the deal – the biggest difference between a Traditional IRA and a Roth IRA is you need to pay tax on the money in a Traditional. But, you can convert a Traditional IRA into a Roth IRA, by paying tax on your traditional IRA.
Think about it, you never paid tax yet on your Traditional IRA, so if you decide to pay those taxes now, on EVERYTHING in your Traditional IRA, BAM – it becomes a Roth IRA! Now your investments will continue growing and you will never need to pay tax on them again!
This is an awesome hack and you should definitely consider it if you’re not eligible for a Roth IRA anymore. Maybe you’re even thinking “wow this sounds sick, why doesn’t everyone do this!”.
Here’s the catch -you can only convert your accounts if you know FOR SURE that you have the money available to pay the tax you owe by April 15th of that year. You do NOT want to convert your account, owe a ton of money in taxes and then not be able to pay that huge tax bill. The IRS will be all over you and it won’t be fun! So just keep that in mind!
Anyway, that’s all I’ve got on Traditional IRA’s today, but don’t worry the fun doesn’t stop there! Check out our post on 401(k)s (link) to see why it is the easiest way to make FREE money.
