Last weekend I got a phone call from my cousin Tootie (not his real name, but a nickname I’ve used for him forever). He’s a junior in college and most of our conversations revolve around sports so I was expecting to get some trouble about Mizzou blowing a 19 point lead against Kansas. Imagine my surprise when he told me that he needed my help settling an argument about Roth IRAs.

He was talking Roth IRAs with a buddy, and his friend said that Roth IRAs are completely tax free. Tootie, being the genius that he is (it’s in his genes), said there was no way something could be completely tax free. He called me to find out which one of them is right.

A Roth IRA SEEMS Tax Free

Tootie’s friend thought a Roth IRA was completely tax free. Some people might say he was right. It sure sounds tax free when you consider the fact that money inside a Roth IRA is not taxed as it grows, nor is it taxed when you take the money out at retirement.

So money in a Roth IRA isn’t taxable and money you take out of a Roth IRA isn’t taxable. So it’s tax free, right?

Wrong.

You Pay Taxes BEFORE the Money Gets in the Roth IRA

The important thing to understand about a Roth IRA is that you can only use earned income for contributions. And as we all know, earned income is subject to federal income tax and state income tax (for states that have one). Depending on your tax bracket and where you live, you could be paying a marginal tax rate of 35% or more when you include federal and state taxes. That’s definitely not “tax free”.

The difference between a Roth IRA and a Traditional IRA is where the money is taxed. A Roth is taxed at the beginning when the money is earned and a Traditional is taxed at the end when the money is taken out, but both are taxed eventually. Uncle Sam wants as much of your tax money as he can get. You can stop him from getting some of your money, but it can’t stop him completely.

A Roth IRA is Still Pretty Awesome!

I don’t want anyone to think I don’t like Roth IRAs. They are super fantastic because they do save you quite a bit of money on taxes. I just wanted to clarify that you won’t avoid paying taxes completely in any IRA, as some people might believe. If you still don’t completely understand the difference between a Traditional and a Roth IRA, I made a little video that explains it completely. Check it out:

Carnival Links

Yakezie Carnival at Financial Success for Young Adults
Canadian Finance Carnival at Canadian Finance Blog
Carnival of Financial Planning at Aaron Hung