Traditional IRA vs Roth IRA

Traditional IRA vs Roth IRA – Understanding The Difference

It’s good to invest for retirement.

It’s even better to invest for retirement if you can also pay less in taxes during the process. That’s what the traditional and Roth IRA provide. They allow you to pay fewer taxes. But they have a few differences, which I will explain below.

The federal government has decided to encourage you to do your own saving for retirement. You see, back in the good ole days, everyone either had a pension from their employer, or they just worked until they died. Only the rich were investing in the stock market.

In the modern era of investing, the pension started to go away. Thus, the government started feeling pressure to take care of older citizens. Because social security isn’t supposed to be a complete answer to your retirement needs, and because Americans started living longer, they needed a solution. They needed something to encourage do-it-yourself investing.

Traditional IRA

Along came ERISA and the traditional IRA in 1974. The traditional IRA is a retirement account in which the contributions you make to that account are tax-deductible. In other words, if you contribute $1,000 to a traditional IRA, you will be able to reduce your taxable income for the year by $1,000. Depending on your tax bracket, this could mean up to $250 in tax savings. All that just for saving for your retirement.

Over the years, the traditional IRA has seen come changes. We now have limits to the amount that you can contribute each year towards your IRA. Also, if you participate in an employer sponsored plan, like a 401K, you will not typically be able to invest tax-deductible dollars into a traditional IRA. Additionally, if you make over a certain amount each year, you will not be able to contribute tax-deductible dollars to your account.

When you pull money out of your traditional IRA (called a distribution), you will have to pay taxes on the money. So even though you skipped the taxes on the way end, you will make it up in retirement. Your contributions and earnings from those contributions will be taxed when you pull them out.

Lastly, you should know that there are penalties if you pull money out of your traditional IRA before you retire, and there are also required minimum distributions you must make starting in retirement. The traditional IRA has a lot of restrictions, but it’s the best place to save for retirement for those without a 401K who are looking for an instant tax deduction.

Roth IRA

That brings us to the Roth IRA. The Roth IRA was created by the in Tax Act of 1997, which was authored by William V. Roth, Jr., a Senator from Delaware. The Roth IRA was aimed at helping people save outside of their employer 401Ks.

You contribute after-tax dollars to a Roth IRA, but when it’s time to withdraw those funds in retirement, you can do so tax-free. Nice, right? Just like the traditional IRA, the Roth has income limits and contribution limits you must deal with. See more at the Roth IRA explained.

Other than that, there’s not much downside. Since the funds are after-tax (meaning you’ve already paid taxes on them), you have a lot more flexibility. You can withdraw your contributions without many limits and you can withdraw them in retirement any time you want. No required minimum distributions.

Traditional IRA vs Roth IRA

A good thing to keep in mind is that if you qualify for both accounts you can certainly contribute to both. There’s no rule saying you can’t. Keep in mind that if you do, you need to watch your contribution limits as those will be spread across both accounts.

The traditional IRA and Roth IRA are both excellent tools to help you get started with your retirement savings effort. It’s more important to get started with something than stopping down because you are stuck deciding which one of these is the best.

As a quick rule of thumb, I like to tell people that if you don’t have a company 401K, then consider the traditional IRA if you want to see some savings to your high tax bill. If you do have a company 401K, then just go with a Roth IRA to do all of your extra investing. That’s what I do.

Once you decide which account to use, you can start thinking about what to put inside your IRA. Good luck.


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Can You Contribute to 401k and IRA

Can You Contribute to a Roth IRA and 401K?

Can you contribute to a Roth IRA and 401k?  Yes, you can contribute to a Roth IRA and 401K at the same time.

In this post I’ll share my experience of simultaneously contributing to a Roth IRA and 401K, as well as the requirements you’ll need to meet in order to do the same.

When it’s time to get serious about your retirement, it’s not a stretch to imagine you might start thinking beyond your 401K. If you have a 401K at work, that’s great. Your employer cares about you and your ability to support yourself in retirement. If your employer is offering a matching contribution, well, you’ve struck gold. That’s free money. The next logical step is to consider a Roth IRA.

Before you consider a Roth IRA, you should be fully taking advantage of your company 401K. By that I mean contributing enough annual dollars to get the full match that the company offers. It’s likely that you are already doing that so let’s dive into the next step of also investing in a Roth IRA.

As a side note, if you don’t have a 401K, then consider reviewing the Difference Between Roth IRA and Traditional IRA.

Difference Between 401K and Roth IRA

Remember that the Roth IRA and 401K are just accounts where you keep your investments. They aren’t actual investments. They are just the account (or vehicle, as some put it) where the money is held. These accounts are great because they get special tax treatment.

You are able to contribute pre-tax dollars to a 401K. This means that no tax is taken from your money that is placed into the 401K. If you earn a dollar and put it in your 401K, you pay $0 in taxes on that dollar. If you earn another dollar and put it in your checking account instead, you have to pay taxes on that money.

There is a limit to your contribution though. It changes every year usually, but right now you can contribute $18,500 (2018) to your 401K.

You can’t contribute pre-tax dollars to a Roth IRA. You can only contribute dollars that have been taxed already. However, unlike a 401K, when you distribute that money to yourself in retirement, you don’t have to pay a tax. Nice, huh? For more on this account see the Roth IRA Explained.

401K and Roth IRA

Because the Roth IRA and 401K have opposite tax treatments, the IRS allows you to contribute to both at the same time. The only thing you have to worry about is the income limitation set on the Roth IRA. Your ability to contribute to a Roth IRA starts to “phase out” at $189,000 (2018) for those who file “married filing jointly”.

Here’s a strategy I follow. To contribute to both of these accounts, just make sure you start with contributions to the 401K to get the match. Then, switch to contributing to the Roth IRA. Once that is maxed out for the year ($5,500 for 2018), then you can go back to the 401K until you reach your annual limit there.

I did that for the tax years 2016 through 2017 and saw significant increased in my tax-advantaged retirement investing accounts. Not to mention, I have two different account with different distribution rules. So now I can consider things like using my Roth IRA for a down payment.

How about you, do you contribute to a Roth IRA and 401K at the same time?


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Stock Valuation – How To Value A Company

Stock Valuation – The Relationship Between A Company’s Stock Price and Cash

In another article titled Companies To Invest In, I made the point that, at its core, a well-run company is simply a money making machine.  That concept – that the value of a company is ultimately tied to cash – is one of the keys to understanding how to value a company and it’s relationship stock price.  Stock valuation are great to get quick snapshot of a company’s value.  I’ll illustrate this point with a simple example, and then build on it in ensuing articles.

How To Value A Company – Cash Per Share Example 1

If there were a company that had $1,000 in cash with 100 shares of stock outstanding then you could calculate the value of each share of stock as follows.

Stock Valuation Cash Per Share Example

How To Value A Company – Acquiring 20% Ownership Example 2

If that were the case and you wanted to own 20% of the company then how much stock would you have to buy, and how much would it cost?  The answer is that you would have to pay a total of $200 for 20 shares of stock, which can be calculated as follows.

Stock Valuation Ownership Example

How To Value A Company – 10:1 Stock Split Example 3

What if the company did a 10 for 1 stock split, meaning instead of having 100 shares outstanding, it had 1,000 shares outstanding?  Would that change the value of the company?  The answer is no.  The company’s only asset is $1,000 of cash, and no amount of stock splitting (or combining) can change that.  However, by doing a 10 for 1 stock split the value of each individual share is diluted, going from $10 to $1 per share.  So in summary, a stock split affects the value of each share of stock, not the value of the company itself, which can be illustrated as follows.

Stock Valuation Stock Split Example

Now, what if our little company went public and was traded on the New York Stock Exchange?  Wow, that’s big time!  Wouldn’t that would boost its stock price above the $1 it’s now trading at after the stock split?  Not at all!  The stock could be traded on the moon, and that still wouldn’t alter the fact that the total assets of the company are worth $1,000, making the value of each of those 1,000 shares equal to $1.

How To Value A Company Using The Terminal Valuation Method

But wait, isn’t just focusing on a company’s cash overly simplistic?  After all, there’s no company of any size or consequence whose only asset is cash.  While that may be true, at the end of the day, determining how to value a company is ultimately measured in money (or cash) – nothing else.  This is known as the terminal value of a company.

The application of this concept is known as the Terminal Valuation Method.  To illustrate how it works, say a company’s stock price is trading at a value that suggests the total worth of the company is $10,000,000.[1]  How can you tell if this stock valuation is reasonable?  One way to go about it is by to pretending that the company sold everything off: its inventory, furniture and fixtures, real property, and so on, until it converted all of its assets to cash.  After going through exercise you estimate that upon liquidating all of its assets and settling all of its outstanding debts (or “liabilities”) that the company would end up with $4,000,000.

“It’s Important To Note Stock Valuation Can Vary Greatly Depending On A Number Of Factors Such As: Industry, Maturity Level of Company, Ect.”

What…$4,000,000?  Didn’t we say that the value of the company’s stock suggested that it was worth $10,000,000?  Does this mean that the company’s stock price is vastly over inflated relative to its true worth? Perhaps, but not necessarily.  For example, aside from tangible assets (assets that you can touch) that could be converted into cash, an established company might have valuable intangible assets that would substantially contribute to its ability to make money: established business relationships, a highly skilled workforce, an efficient supply chain, secret formulas and patents, widely recognized brands and trademarks, etc.  In short, there can be a lot more to the value of a company than just its “hard assets” such as cash, inventory, property, etc.

However (and this is a BIG however), if a company is being valued at $10,000,000 and yet it would only be worth $4,000,000 upon liquidation, there still has to be a financial explanation for where that remaining $6,000,000 of value is coming from.  In other words, what is it about the company that makes it worth more than sum of its tangible assets?  If there is a compelling story there – a story that explains how the company’s business prospects, activities and operations are worth an extra $6,000,000 – then the stock valuation of the company can be justified.  If not then the company’s stock price is being pumped up by hype and hot air.

Summary

While it’s true that you cannot you cannot fully measure the value of a company based on its hard assets (cash, inventory, buildings, etc.), it’s also true that a company’s value is ultimately measured in dollars.  That means when it comes to a company’s stock valuation, cash is king!


[1] This would be the case if, for example, a company’s stock was trading at $50 a share and there were 200,000 total shares outstanding ($50 x 200,000 shares = $10,000,000).