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Roth IRAs | Finance & Capital Markets | Khan Academy - YouTube
Channel: Khan Academy
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What I want to do in this
video is to give you the gist
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of what the Roth IRA is all about.
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Just to get an idea of why
it's called the Roth IRA,
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it's named after William Roth,
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the late senator from Delaware.
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He helped, I guess,
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you could say shepherd
this legislation in 1997
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when it was first passed
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so they named the IRA after him.
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William Roth from Delaware.
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That's where the word comes from.
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It's a special type of
individual retirement account.
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Why did they go to the
trouble of creating a new one?
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Let's think about what
a traditional IRA does
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and then I'll talk about why a
Roth IRA could be interesting
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or it's a little bit different
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or what could be beneficial
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and then we'll actually
see it in an example.
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The first question is what
happens when you put money
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into a traditional or a Roth IRA?
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In the traditional IRA video
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you saw that it's tax deferred.
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That if you were to put
$5,000 in your traditional IRA
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you are not taxed on that money.
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In the Roth IRA it is not deferred
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so you would actually
pay taxes on that $5,000.
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Immediately you're saying,"Hey gee.
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"This doesn't seem like
that great of a thing.
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"Why would I ever use it?
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"I have to pay taxes on
the money I've put in."
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This is the interesting thing.
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In both situations, as long
as your investments stay in
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either traditional or Roth accounts
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earnings are not taxed while in account.
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This is true for both of them.
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But you're still going to say, "Hey Sal.
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"The traditional still looks a lot better.
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"I had to pay taxes on the
Roth right from the get-go.
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"I didn't have to pay
it on the traditional.
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"Then they can both grow
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"and I can buy and sell my stocks
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"or invest in mutual funds
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"or whatever I do inside of them.
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"I don't pay taxes.
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"The traditional still looks better."
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Now, the interesting thing is what happens
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when you withdraw the money?
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There's a lot of special circumstances
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on when a withdrawal is qualified or not.
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I'm not going to know the details
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I really just want to give you the essence
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of why the Roth is interesting.
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Let's say you're over 59-1/2 years old
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and in the Roth.
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Your money has been there
for more than 5 years,
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it's been seasoned.
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I'm not going to go into
all of the particulars.
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The traditional IRA when you withdraw,
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let's say we're older than 59-1/2 for both
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and then we do a withdrawal.
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In the traditional IRA
you have to pay taxes.
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You pay taxes, you're taxed.
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Ordinary income tax.
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While in the Roth IRA no taxes. Not taxed.
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We saw in the traditional IRA video
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that this has to be pretty good
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when you're older than 59-1/2.
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You might be retired.
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You might be in a lower tax bracket.
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You're going to pay lower taxes on it
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and it's been deferred
for however many years
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your IRA has been in existence.
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This is especially interesting
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because over here you paid tax
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just on the original
amount that you've put in
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and then you'll allow that
original amount to grow
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over many, many, many years
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and then all of a sudden
you're not taxed at all.
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That, all of a sudden, becomes
a little bit interesting.
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This seems like a pretty
good thing to have.
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We're going to actually
play with the numbers
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to see how they workout.
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Now, the other interesting
thing about the Roth
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is if you early withdrawal.
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For a traditional IRA you pay 10% penalty
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on the withdrawal plus you get taxed.
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Plus taxes.
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On the Roth IRA if you're just
taking the original amount
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you've put in
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and I'll do this with a numerical example.
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If you're just taking
out your principal amount
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no taxes or penalty on the principal.
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No taxes or penalty on principal.
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And you would only have to pay
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even if it's a non-qualified withdrawal.
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There's all these special
circumstances, what's qualified
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and I'm not going to go to the details.
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You would only have to pay the 10% penalty
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and taxes on earnings.
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One of the main reasons
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why I'm not going in
all the details is one:
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It would make the video
a little confusing,
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but also, the government
is constantly changing
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the details.
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I want you to be able to watch this video
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as many years in the
future and not to be dated
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so I don't want to go into
all of the different things
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that the government is
changing from year to year.
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Let's just do a very basic example
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just to get the sense of things.
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Let's look at at a traditional IRA
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and then we have a Roth.
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Let me write IRA just to be clear
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that we're talking about an
IRA in both circumstances.
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Let's say my original income amount,
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let's say I've made more than $5,000.
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I'll just use $5,000 as my example
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and I'll also make another note.
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Roth IRA is subject to more limitations
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in terms of your total overall income
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and that's also changing.
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I don't want to be
specific on the numbers.
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You could look that up.
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There are ways that you can
transfer traditional IRAs
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into Roth IRAs.
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That's a little bit of a loophole
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on being able to get around
some of those restrictions.
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But anyway, I won't go
into the details just yet.
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Just remember, Roth IRA,
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there are some more limitations
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on whether or not you
can put things into it.
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If you're tricky you might
be able to get around them.
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Let's say you have $5,000.
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And just so you know, the limits on IRA
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is they apply to Roth or traditional
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or any combination of the two.
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If you're starting with $5,000,
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so in the traditional IRA
you have 0 taxes initially.
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In your Roth IRA initially,
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let's say you have a 32% tax bracket
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just like in the previous video.
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32% of tax bracket.
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Then you'll pay 32% on
$5,000, 32% on $5,000.
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That's .32 x $5,000. That's $1,600.
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You're going to pay $1,600 in taxes.
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Your amount in the account,
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in your account, your principal,
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in your traditional IRA
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and maybe I should write it out here.
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Starting with that $5,000 your principal
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is going to be $5,000 here.
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You have to take 1,600 out for taxes
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so it's only going to
be $3,400 right there.
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Let's say in either situation
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you were to take that,
invest it in some stocks
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and then 5 years later it doubles.
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Let's say at some future point it doubles
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and you sell those stocks.
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That becomes $10,000 in your account there
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and then this, you invest
it in stocks and it doubles.
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This becomes $7,800 in
your account right here.
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This is 5 years into the future.
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I'm just picking that into the future.
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Let's say we're still not
59-1/2 years old just yet.
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Now, we could just continue to leave
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either of these amounts in our account
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until we're 59-1/2.
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Let's say we have some type of need,
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we need to give a loan to our
brother-in-law or something.
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We really want to have
access to this money.
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Let's look at the situation
where we withdraw.
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If we were to withdraw,
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let's think of a couple of situations.
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If we were to withdraw $3,400.
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Let's say that exactly what
my brother-in-law needs
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just right now.
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If we were to withdraw $3,400
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in the traditional IRA sense,
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in the traditional IRA case.
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We take out $3,400. We're
going to have to do 2 things:
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First, we're going to
have to pay taxes on it.
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We're going to have to pay 32% of that
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assuming we're still in
the same tax bracket.
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$3,400 x .32 is equal to,
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we're going to have pay $1,088 in taxes.
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We're going to have to
pay $1,088 in taxes.
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We're also going to have to pay a penalty
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on this entire amount, on the $3,400.
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We're also going to
have to pay 10% penalty,
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$340 penalty.
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We're going to be left with
after paying all of these,
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let me get the calculator
out and let's see,
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the calculator right there.
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We're going to be left with
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3,400 - 1,088 - $340 = $1,972.
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We're left with $1,972.
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In the Roth IRA,
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when you needed that money all of a sudden
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and you decided to withdraw it early
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and we're only taking out $3,400.
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We're taking the amount that
was our original principal.
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In the Roth IRA we get the $3,400
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because that was our original amount
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and we pay no taxes or penalties.
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At any point in time on the Roth IRA
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you can always take your principal out.
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In the other types of IRAs
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not only will you have to pay taxes on it,
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you're also going to have to
pay a penalty on top of that.
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The Roth IRA, one of
the very positive things
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is it gives you a lot of flexibility.
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Now, let's say you needed
to withdraw, I don't know,
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let's say you needed to withdraw $4,000.
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This is another scenario, $4,000
at this same point in time.
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Within the traditional IRA scenario,
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once again, you're
going to have to pay 32%
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of that in taxes. You're
going to have to pay
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4,000 x 32% in taxes
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and you're also going to have to pay
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+ $400 penalty.
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In the Roth IRA case, you pay nothing.
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You get the original
principal you have put in,
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that was your original amount, $3,400.
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In all of this, I'm assuming
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that we're not 59-1/2 years old just yet.
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In the Roth situation,
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you get the $3,400 free and
clear, tax and penalty free.
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But the other $600, you're
going to have to pay 32% taxes
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or whatever your tax bracket is
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and then you're also
going to have to pay $60,
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a 10% penalty on just
the earnings portion.
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Remember, 3,400 was your principal,
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then if you want to take
4,000 out, the 600 extra,
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that stuff that you earned.
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That stuff that was
grown from the principal.
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You're going to have to pay
plus another $60 penalty.
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But it's still a much better
situation if you do the math
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than this one here.
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In general, if you
think, if you're not sure
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whether you're going to need that money
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before you retire,
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the Roth gives you a lot more flexibility.
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Now, let's go all the way to retirement.
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Let's go all the way to retirement.
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Let's say we didn't
ever withdrew any money.
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We invest it in another stock
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and so we go 10 years later.
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We never withdrew any money.
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We're just going to look at
the retirement situation.
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We go to our stock and we
sell it, our new stock.
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We get the 20,00 there,
here we get $15,600.
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Of course, in both of these situations
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its great that we're able
to buy and sell stocks
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inside of these retirement accounts
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and not pay taxes.
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If these were not sitting
in retirement accounts
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every time we bought and sold the stocks
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we would have to pay capital gains tax
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and you saw that in the previous video.
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Now, now that we are over,
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let's say we're 60 years old.
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We can now withdraw our
money from either situation.
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There's some other stipulations,
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your money has to be seized
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and has to be sitting
there for 5 years and all
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but I won't go into the details.
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Let's see what happens
when we withdraw the money.
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Let's say we have a 25% tax bracket now.
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25% tax bracket.
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We're retiree, we're earning
a little bit less money,
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we are in a lower tax bracket.
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In this situation we're going to pay,
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when we withdraw it from a traditional IRA
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we are going to pay 25% in
taxes which is $5,000 in taxes
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and we are going to be left
with $15,000 for ourselves
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to spend in our retirement years.
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In the Roth IRA situation,
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once we're over 60 years
old our tax bracket
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doesn't matter.
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We just get the money,
$15,600 free and clear.
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If you think about it in either situation,
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when we withdrew early,
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the Roth IRA was much more forgiving
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especially if we withdraw
less than the amount
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that we originally put in, $3,400.
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The Roth IRA does not tax us
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or give us penalties.
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It only does that on any
money that we earned,
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any money in excess of the $3,400.
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The traditional IRA
taxes us and penalizes us
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on everything.
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Even when we go into the future, remember,
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in the traditional IRA
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we didn't pay any taxes to begin with
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but we had to pay taxes to end with.
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When we paid taxes in the end,
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we're paying taxes not just
on what we've put in initially
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we're also paying taxes on all of
our cumulative earnings, right?
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We originally put in 5,000,
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now we're paying taxes on 20,000.
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We're going to only end up with $15,000
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while in the Roth IRA we
don't pay taxes on anything.
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In return for being willing
to pay our taxes front loaded
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to pay them in the beginning,
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we'll never have to
pay taxes on that money
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or on any of the earnings
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that that money makes.
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Now, I fixed the numbers
here to make them close.
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Depending on your tax
bracket before and after
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or how much growth you
actually see in your earnings,
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one maybe better than the other.
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But these are important considerations.
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I just want to let you
know the pros and cons.
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The Roth IRA tends to be better
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in terms of giving you this flexibility
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and not worrying to pay taxes at the end.
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There's one other thing,
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this is depending on how you view life,
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it might be a minor thing.
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In the traditional IRA, when you're 70-1/2
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they force withdrawal
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and then of course you have to
start paying taxes on things.
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In a Roth IRA, there's no age limit.
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That's another consideration
you might want to take into.
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