Roth IRAs | Finance & Capital Markets | Khan Academy
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Roth IRAs | Finance & Capital Markets | Khan Academy

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.

About James Carlton

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43 thoughts on “Roth IRAs | Finance & Capital Markets | Khan Academy

  1. He already has, look it up. watch?v= uGpLS_pr7oc
    Remove the space in that url and add it to the end of youtube dot com

  2. Because of the 7800 mistake, the traditional IRA would give you $15,000 after 60 years and the Roth IRA would give you $13600 after 60 years so the traditional IRA is still better for you in this example.

  3. What I take from this is that if there is any possibility of needing the money prior to retirement then go Roth. If you are sure that your tax bracket will be lower (or as insurance that it could be) then take Traditional instead. But if your tax bracket remains the same then there is little benefit in traditional as the penalties for early withdrawal are more severe than with roth…

  4. you end up paying taxes on all 401 related dollars (either principal or bonus) anyways. I think traditional IRA sits well with Mr. Mind only if you are sure not to mess with early withdrawals and you are sure to be in lower tax bracket when you retire. Provided in lower tax bracket when you retire, why would you ever get your IRA $s taxed at high tax bracket when you are young. 

  5. Dude you made multiple math errors. The 6800 and when you minus, minus without (bracket) you subtract the second minus from the the first minus.

  6. The end value of Roth IRA only amounts to 13600$ in actual(your final amount is wrong in this video, since you made multiplication errors initially), compared to 15000$ in Traditional IRA. I do not get the point why Roth IRA is better, when the final return are less? Can you please elaborate on that?

  7. Assuming 4x Growth and 32% ordinary income tax

    Traditional IRA: $5000 (pre-taxed principal investment) x4 growth = $20,000 – 6,400 tax (32%) = $13,600 at age 59.5

    Roth IRA: $5000 – 1600 income tax = $3,400 invested principal x4 growth = $13,600 at age 59.5 tax free

    Looks the same to me.
    Traditional IRA is better if you belong in a lower tax bracket at retirement. Roth IRA is better if your tax bracket is lower at investment age than retirement.
    Even though you can withdraw principle tax free in a Roth, doing so would cut into your growth, which negatively impacts your potential returns.

  8. worst video ever XD his math is wrong and that makes the difference on the IRA comparison. 3400 x 2 = 6800 not 7800 lol, how did he never notice that. the Roth IRA gives out less money upon retirement in this scenario, if the retiree is in a lower tax bracket XD you don't even need math to figure that out

  9. one thing I don't like in this video is you make it appear as if you have to pay taxes on money you put into a Roth as soon as you put it in.     Roth is after tax dollars,   regular IRA is with pretax dollars.      You aren't gonna care about taxes on the Roth cause you already paid them in your paycheck before you even got it.

  10. so everytime I put let's say $100 into my Roth IRA out of my paycheck I have to pay tax on that $100 or since those earnings are already subject to income tax I do not need to pay let's say 32% on that $100 post income tax money I want in my roth?

  11. he clearly did the math wrong. if he did it right. after retirement with the ROTH IRA you would have 13,600 not 15,600. that makes the traditional IRA better after retirement.

  12. Questions if the market is bad

    1) If you contributed lets say 2000$, what happens when your balance at the end of the year is 1800$, less than your contributions? Would you only be able to withdraw 1800$ or the full 2000$ that you contributed?

    2) Also with the same scenario, will the earnings next year be based on my total contributions of 2000$ or the current balance in the roth IRA of 1800$?

  13. Roth IRA contributions are not tax-deductible. However, eligible distributions are tax-free. This means, you contribute to a Roth IRA with after-tax dollars, but as the account grows, you do not face any taxes on capital gains, and when you retire, you can withdraw from the account without incurring any income taxes on your withdrawals.

  14. Wow, math mistake screws everything up, also logical mistake screws it even more.
    Let's say we doubled the money, 10k vs 6.8k.
    You need to get 3400, not to withdraw 3400.
    So in traditional you have to withdraw
    5862.07 this yields you 3400 after .32+.10
    Leaving 4137.93 in account to earn interest, while in Roth you get 3400, leaving 3400 earning interest.

  15. Usually, one's net result with the logic in this video will be of similar earnings between a traditional and a Roth I.R.A. (despite the math errors herein). What is not often enough mentioned is, the Roth will much outweigh the traditional if the initial principal between the two accounts is the same (rather than the Roth's being relatively reduced by taxes).

  16. Roth seems better intuitively, maybe because it feels good to handle costs upfront, but considering inflation will lower the value of money over time it also makes sense to defer payments to the future, but then taking into account that all of the investment gains will be taxed makes it so that some math is involved. I suspect it's a wash that could go either way.

  17. Why would you not place $5000 in the Roth account? It is already taxed. For his illustration purposes it would have been better to show both of them growing and starting from $5000.

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