Ice Cream and Investing. Wait, what?

July 27, 2019

Investing in a Roth IRA...  What does that really mean?

I get this question or something along this line regularly.  Interestingly enough, my wife asked me this very thing just after a stop at Dairy Queen, and it led me to an out of the box analogy, but I think it works!

So think of a Roth IRA or a 401(k) or a 403(b) or an IRA or any other account type you can think of as the Cup that holds the Ice Cream.  Each cup can be a different color or size, but they can all hold whatever type of Ice Cream you choose.  Think of the Ice Cream as the investment.

In this analogy, the actual investment doesn’t matter, but since we’re thinking about Ice Cream already, maybe the “flavor of your dessert” is stock in Dairy Queen.  Sidebar - it would be tough to actually buy DQ stock as it’s privately owned by Berkshire Hathaway – Warren Buffett’s company - but let’s ignore that for today.

Anyways, in our little hypothetical world you can buy that stock in DQ and get it served to you in any number of Cup colors or sizes (account types).  The Ice Cream tastes the same no matter what Cup you use, and no, we’re not considering cones today, only Cups!  Similarly, an investment performs the same way in whatever account type you have.   The biggest difference in these accounts (Cups) is the way your investment (Ice Cream) is taxed.

Ok, the analogy gets a little confusing here but see if you can stay with me…

For ease of comparison, we’ll say a Red Cup is a Roth IRA (IRA stands for Individual Retirement Account) and a Blue Cup is an IRA (also known as IRA Rollover or Traditional IRA).  The ice cream in the Red Cup is funded with “after tax” money while the Blue Cup is funded with “pre-tax” money. 

So if the DQ stock grows in value over time, when you sell that stock from the Red Cup (after reaching 59.5 years of age and holding the account open for 5 years or more), that growth would not be subject to income tax at the time of the sale.  You already paid tax on the investment before you put it into the Roth IRA/Red Cup, and the Roth IRA is an account type that allows for tax free growth potential under certain conditions.

If, however, you put that delicious DQ stock into the Blue Cup, then when you withdrawal the money in retirement you are taxed on all of your withdrawal based on your current income tax rates.  Remember though - by initially investing into the IRA/Blue Cup, you would not have paid tax on the funds when you invested, and you could have deducted the invested amount from that year’s income and saved on your tax bill in that year.

 

Clear as mud?

Bottom line is to remember 3 things:

1 - Account types and investments are separate things and largely independent of each other.

2 - Account types have different tax treatments.

3 - The investment can be just about any security and it can be conservative, aggressive or anywhere in between.

 

 

This is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.

IRA withdrawals are taxed as ordinary income and may be subject to a 10% federal tax penalty if withdrawn prior to age 59 1/2.

Roth IRA contributions are subject to income limitations.  Roth IRA earnings withdrawn prior to the end of the Roth IRA five-year aging period and prior to reaching age 59½ will be subject to a 10% early withdrawal penalty unless used to meet qualified expenses.  A distribution from a Roth IRA is tax-free and penalty-free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, death, disability, or qualified first-time home purchase.

Waddell & Reed and its representatives do not offer tax advice.

Neither Jones Financial Group nor Waddell & Reed are not affiliated with Dairy Queen, Berkshire Hathaway or Warren Buffett.  

07/19