Why I Switched to the Roth IRA
I still remember in high school when the difference in Traditional and Roth IRAs was explained to me. I guess this is when they still taught budgeting home finance and financial planning in high school
The biggest difference that the teacher pointed out was the way each IRA was taxed.
For Traditional IRAs, the amount was taxed when you withdrew the funds: this included the principle that you had deposited throughout your life and any compounded interest was taxed.
Roth IRAs were taxed immediately but then any compounded interest was not taxed.
Two things struck me about this conversation struck me:
- If I invested in a Traditional IRA, I would have more to invest if the amount deposited was not taxed first.
- I would not be making much money when I started withdrawing my retirement funds so why would I need to worry the government taxing my retirement funds.
If you can’t tell this turned out to be bad advice. Eventually, I made the decision to switch from Traditional IRAs to Roth IRAs and I thought I would share my reasoning.
Why I switched my retirement strategy from Traditional IRAs to Roth IRA
There are three primary reasons I made the switch. The first two are pretty obvious but the last one may surprise you.
1) Compounding interest is not taxed
Anyone who looks at IRA programs will realize that, by definition, this is the most obvious difference in the two types of IRAs.
However, compound interest is a big deal and not being taxed on your compound interest is a big deal. This is why the government limits how much you can invest in your IRA.
If you contribute $500 a month over 40 years, your total contributions will be $240k.
When you look at total savings with a modest compound interest rate of 7%, the total retirement amount is about $1,197,810. Not bad from a total investment of $240k.
I would much rather pay taxes on $240k then nearly $1.2 million.
2) You are still going to be taxed when you retire
Most people think that when they retire they are not going to have to pay that much in taxes. When I was young I thought, “I’m not going to have a job. My taxes are going to be very small.”
This is a common misconception.
If you have a Traditional IRA, when you pull the money out, you are going to have to pay taxes on it. If you need $60k a year to maintain your current lifestyle, you are going to pay a portion of that in taxes when you withdraw the funds.
If your funds are in a Roth IRA, when you withdraw the funds, be it $60k or $100k, you will not have to pay taxes on it.
I don’t have a crystal ball and I don’t know how much your cost of living will be when you retire, but I don’t want to worry about how much taxes I will be paying when I retire.
3) I’m scared about losing my job in my 50s
A couple of years ago, one of my friends retired from a manufacturing position after working for just over 20+ years to pursue his dream job as a hunting and fishing guide. He was in his late 40s.
I was totally envious of the decision. However, one day the horse he was riding bucked, he went flying off and he broke his back. He was not going to be able to go back to the active lifestyle his dream job required with his new injuries.
Instead of retiring and living off his pension and retirement in his 50s, he learned he was still too young to withdrawal his retirement funds without a significant penalty. He ended up working minimum wage jobs for a while just to make ends meet.
(Side note: he is a really good worker and after a couple of years, he worked his way up the ranks until he was managing a large manufacturing plant again.)
The point of this story is, it can be hard to transition to a new job in your 50s. I am paranoid that I will get laid off or something will happen to my health later in life. If something unfortunate happens, I may need access to my retirement funds before I plan on retiring at the old age of 72.
For Traditional IRAs, you have to wait until you are 59 1/2 to withdraw your money without penalties. Bummer.
For Roth IRAs, since you already paid taxes on the contributions, you can withdraw funds tax-free and penalty-free at any time.
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Planning for retirement may seem like something you can postpone and don’t need to think about because you will not see the results of your hard work for 30 or 40 years.
However, the amount of time before you retire gives you plenty of time to plan a strategy, calculate how much you need to save, and refine your retirement plans to match your current lifestyle.
