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Roth IRA vs Traditional IRA
Individual Retirement Accounts (IRAs) are great for any kind of income investing, including covered call writing. No record keeping of individual trades is required, and your gains compound tax-deferred.
The two main types of IRAs are the Roth IRA and the Traditional IRA (the latter is also known as a "deductible IRA"). The difference between them is that Roth IRA contributions are post-tax dollars (and offer tax-free withdrawals), while traditional IRA contributions are pre-tax dollars (and offer taxable withdrawals). Here's a summary:
| Taxable Account | Roth IRA | Deductible IRA |
|---|---|---|
| You pay income tax, and then make contributions with post-tax dollars |
same as Taxable Account |
You contribute pre-tax dollars and get a tax deduction today |
| Your investments are subject to taxes on dividends and capital gains as they grow |
Your investments grow tax-free |
Your investments grow tax-free |
| You pay capital gains tax on your gain at withdrawal |
No taxes on withdrawal |
You pay income tax on entire amount of withdrawal |
Comparing a Roth IRA to a Traditional IRA
- Roth IRA requires no special reporting to the IRS. A Traditional IRA requires you to report the initial deduction on your 1040 and then report each withdrawal as income once you start withdrawing.
- Traditional IRA requires withdrawals to begin by age 70.5; Roth IRA does not require you to begin withdrawing by a set age.
- Roth IRA pays taxes today, while Traditional IRA pays taxes during the withdrawal years. If you believe taxes will be higher in the future then you may pay a lower rate with a Roth IRA today than with a Traditional IRA in the future.
- In both cases contributions are limited based on your income and age (generally around $5-6K per year, see IRS Pub 590a for details).
- In both cases your investment gains will grow/compound tax-deferred.
This last point, regarding tax-deferred compounding gains, is the real benefit of IRA accounts (either kind). The effects of compounding gains are dramatic the longer you have the account. Here's a comparison of a taxable account and non-taxable account earning 1.5%/month in covered call income. In both cases we start with $10K and do not contribute anything else. We assume 28% tax bracket for the Taxable Account. Compare account size after 20 years:
| Years | IRA | Taxable Account |
|---|---|---|
| 0 | $10,000 | $10,000 |
| 5 | $24,432 | $20,993 |
| 10 | $59,693 | $42,798 |
| 15 | $145,844 | $87,251 |
| 20 | $356,328 | $177,878 |
The results are even more impressive (in favor of the IRA) if we assume new contributions each year. The bottom line is that compounding gains are powerful over time. The choice of Roth IRA or Traditional IRA is not as important as the choice to contribute to your IRA each year (assuming you can; there are income limits that may prevent you from doing so). As Nike would say: Just do it! Even a small contribution is better than none.
Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.