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I'm a young adult who currently invest in Vanguard index fund using money from my paycheck, which is already taxed.

What is the difference of doing this compared to put the money into a Roth IRA first, then tell my IRA provider to invest in index fund?

To me, it seems like the Roth IRA is better than and has no downside compared to my current situation of using non IRA. The Roth IRA takes in money after tax (similar to my current situation) but allows earnings to grow tax free (better than my current situation, in which I have to pay long-term capital gain tax when I withdraw).

Even if I have to withdraw early from the Roth IRA, the penalty is 10% only on the earnings, which is still lower than the long-term capital gain tax on my earnings.

Is this understanding correct?

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    The beginning of your question apparently asks about a taxable account vs. an IRA, and then later you ask about a Roth IRA. Are you just asking about the difference between these three options, or is there something more specific? – BrenBarn Oct 28 '15 at 7:41
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There are 3 account types your question discusses and each has its good/bad points.

  • Non-Retirement account - It's available for your use, the tax on selling is taxed at the long term gain rate if held over a year. Dividends along the way are also taxed favorably. At retirement, using this money does not count as taxable income which would otherwise trigger tax on Social Security income (or a phaseout if politicians have their way) and if high enough, medicare.
  • Traditional IRA - this money goes in pretax, grows, and is taxed as ordinary income on withdrawal after age 59-1/2. In effect, it lets you smooth your marginal tax rate over time, ideally by using this type of account when in the 25% bracket or higher, then paying a lower rate on withdrawal.
  • Roth IRA - Best when in a low bracket, 15% or lower. Money goes in post tax, but is never taxed again. Withdrawals before 59-1/2 of deposits only are penalty free, the growth would be subject to both tax and penalty. Note, if the account doubles, and you withdraw the whole thing, pre-59-1/2, the gain is subject to both ordinary tax, not long term gain, and the 10% penalty. This is the downside you asked about.

The above is a snapshot of these account types. IRAs have income restrictions that may disallow a deduction on the traditional, or any deposit to Roth, etc.

If this does not address your question, please comment, and I'll edit for better clarity.

  • My main question is: Is Roth IRA always better than non retirement account? Both have money go in post tax, but Roth IRA earning grow tax free whereas in non retirement account earning has capital gain tax. Even the penalty of wit drawing early on Roth IRA earning is only 10%, still smaller than long term capital gain tax. – Heisenberg Oct 28 '15 at 15:04
  • Note that you can't just withdraw the earnings, there's a specific order withdrawals occur in, and earnings are last on the list, you have to have withdrawn all contributions and conversions first. Also, there are lower and upper income limits on when you can contribute to a Roth, and there are (fairly low in my opinion :-) ) contribution limits. So for most people, it's not Roth vs. non-retirement, it's Roth then non-retirement (or Roth then 401k then non-retirement), and that's assuming you can make Roth contributions at all. – blm Oct 28 '15 at 16:39
  • @blm - all true. I kept it short until I knew his exact intention. I edited to emphasize cost of early withdrawals. – JoeTaxpayer Oct 28 '15 at 18:27
  • You can only put $5500/yr in an IRA. Also, depending on income you may not be able to deduct contribs to a traditional. – AbraCadaver Oct 28 '15 at 19:15
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    I think they key point @JoeTaxpayer makes is "if you withdraw the whole thing, pre-59.5, the gain is subject to both ordinary tax, not long term gain, and the 10% penalty." This means that Roth IRA early withdrawal (which result in income tax + 10%) is worse than non-IRA withdrawal (which result in long term capital gain tax only), correct? Especially since income tax is probably higher than long term capital gain tax. – Heisenberg Oct 28 '15 at 19:25

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