Roth and Traditional IRAs

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Image Source: http://www.freepressjournal.in

You finally make some money trading, but then you realize that you have to pay a huge amount of short-term capital gains taxes. You start wondering if there’s a way to actually not pay short-term capital gains taxes at all, and then you come across the magical Roth IRA…

The Roth IRA and Traditional IRAs are retirement accounts that currently allow a maximum contribution of $5,500 a year (for 2017 and 2018). You must have earned at least $5,500 for that given year from whatever income source – this includes money you made trading stocks, in order to be eligible for making the contribution. 

Roth IRA diagram.PNG

Source: https://www.rothira.com/2017-roth-ira-limits-announced

In a Roth IRA, once you pay your taxes for the year, you can deposit the contribution into your account. The capital gains you make in the Roth IRA account are not taxed, meaning when you withdraw your money, you get to keep the entire sum without paying a penny of taxes. Great, isn’t it? You have until April 18th, 2018 to make your 2017 contribution! Just wait, it gets even better. 

It’s also really easy to setup, and takes less than 10 minutes to do. I use Charles Schwab as my broker, but your broker might do things differently. Simply log onto your broker’s website, make a Roth IRA account, and then electronically transfer your money from your regular stock trading account into the Roth IRA account.

The “Traditional IRA,” differs from the Roth IRA in that you don’t pay taxes when you put money into the account, but pay taxes when you withdraw from the account. When you withdraw from the account, earnings from dividends, capital gains, and interest are all taxed like ordinary income at your then-current tax bracket

For example, let’s say you earned $50,000 this year from your day job before taxes have been paid. You can take up to $5,500 from that day job (pre-tax) and move it directly into your Traditional IRA account. 

You can only make a maximum combined $5,500 contribution to your Roth and Traditional IRA accounts, meaning if you put $5,500 into your Roth IRA for 2017, you can’t make a contribution to your Traditional IRA for 2017. 

Remember that compounding interest can make you rich, so make your contributions ASAP!

Takeaways: Capital-gains (money you make trading in the account) are not taxed in the Roth IRA. You take post-taxed income and add it to your Roth IRA. For Traditional IRAs, you are taxed at your then-current tax bracket when you withdraw money from the account. If you think your current tax bracket will be lower than the tax bracket when you retire, you should add money into your Roth IRA. If you think your tax bracket will be lower when you retire, you should make contributions to your Traditional IRA.

Or you can be cool like me, and add a little to both IRA accounts such that the sum of the contributions adds up to $5,500.