Happy day to you. This is Ken Kaufman and I am thrilled you’re here for episode number 82, “Roth vs. Traditional IRA.” Now, there is plenty of discussion and information online. I wanted to just do this episode to share with you my perspectives in how I understand these things, and hopefully give you some insights so that you can make a decision of if you should be funding a Roth or a traditional IRA. And I will also say most employer-sponsored 401(k) plans also offer a similar option of Roth versus a traditional 401(k) funding option. And the characteristics that I’m going to identify here between the two exist almost the same in that employer-sponsored plan. So you should be able to take this logic and roll it over to that as you think about and consider what you wanna do with your employer-sponsored plan and then any additional funding that you wanna do of additional IRA accounts.
Now, the thing that these two account characterizations have in common is that the money that is in them grows tax-deferred huge, amazing benefit and can save lots and lots of money, especially over the long-term from the interest, and dividends, and capital gains that can be realized on whatever you’re choosing to invest those funds in, whether it’s a Roth or a traditional IRA. The main difference between the two, there are other smaller differences, I’m focusing on main differences, the traditional IRA, the money that you put into it can be deducted from your taxes. So we’re sitting in the year 2020, and if you’re under 50 years old, the maximum you can put in, at least into a traditional IRA at a financial institution, not a 401(k) plan, is $6,000. So if you put $6,000 into the plan and your income isn’t above a certain threshold, you are able to deduct $6,000 from your taxable income for that year. That’s a big benefit, especially if you’re in a very high tax bracket. Six thousand dollar deduction, the highest tax bracket is at 37% currently. So that’s well over $2,000 of potential tax savings in a year. That’s a big deal. On the flip side, the Roth IRA… Oh, and the traditional IRA, so the money that goes in can be tax deductible, but then when you take your money out, it is all taxable at whatever your tax bracket rate is. And the government does, once you hit age 70 and a half, it does compel you to have to take what are called minimum required distributions because they don’t want that money sitting tax-sheltered forever, and they want to see that money start to come out. And so as it comes out, it is taxable.
Now, when we make a comparison of that funding mechanism and the benefits that come with it, the traditional IRA, the Roth IRA is exactly the opposite. The money that you put into the Roth IRA is not deductible against your current year’s income. But the proceeds that you take out of the Roth IRA, whenever it is that you’re going to access those funds, are completely tax-free. Now, the account has to have existed for five years and there’s a few other little minor details, I’m not getting into any of those details, I just want you to understand this major overlaying concept, that the difference between these two is, is the money going in taxable or tax-free, and when it’s coming out, are those funds taxable or tax-free?
So now we have this debate, and the interesting thing is, because I’ve done some research, created spreadsheets, looked at all of this to see which one is actually better. And it really does come down to just one main decision. And that one main decision is deciding, is your tax bracket that you’re in, your marginal tax bracket, not your effective tax rate where you figure out, “Hey, how much tax did I pay against my adjusted gross income?” come up with a percentage. I’m talking about the marginal bracket. So for each extra $1 you earned, what is the tax rate at that bracket, which would be the highest bracket that your income is being taxed at. Because the government, the way that our tax system works is, it’s broken up into these segments where up to a certain income is taxed at a certain rate. And then if you have more income than that, then it’s taxed at a higher rate. And then if you have more income above that threshold, then that’s taxed at a higher rate. So I’m looking for that highest marginal tax rate. Meaning, if you made one more dollar, what would it be taxed at? And in the scenario that we’re discussing here about traditional versus Roth, knowing and understanding that if I’m in a really tax bracket right now, and I could take that tax benefit right now, and I perceive that in the future the tax bracket that I will be in when I retire or when I wanna start accessing my funds is gonna be lower, then it is actually more advantageous to fund that traditional IRA from just a numbers perspective.
Now on the flip side, if you think that you’re going to be taxed at a higher tax bracket when you’re taking the money out versus today, then generally it makes more sense to seriously consider the Roth. And the most interesting thing is I went through and I ran the numbers. I ran scenarios from 1 year to 40 years. I layered all the tax brackets in. I went through everything, and no matter what scenarios I plugged in, the numbers actually work out the same, where if, let’s say that I’m in a 24% marginal tax bracket and I put $6,000 into an IRA. Well, when I put the $6,000 in to a traditional IRA, but as it grows, and I assume that over 20 years it would grow at a rate of 7%. Pick whatever investment portfolio you think that is. I’m not promising any returns. This is merely for illustrative purposes in this discussion. So I’m in this 24% tax bracket, 7% growth compounded annually over 20 years. What that means is that my $6,000 that I put into the Roth IRA after I adjusted it down to $4,560 because the funds were taxable, so I had extra tax that I had to pay, so it’s basically nominalizing that amount, it will turn into, at the end of 20 years, $17,646. And I could take all that money out. Now, the interesting thing, though, is if I had chosen to go traditional instead of that, a full $6,000 would have gone in because I didn’t have this extra tax that I had to pay, or better yet, I should say I had a deduction against my taxable income. Instead of growing to $17,646 like the Roth option did, in this instance, it grew to $23,218. However, in that traditional IRA when I take the money out it’s taxed and guess what happens when you apply the 24% bracket? It is the exact same dollar amount, $17,646. The exact same dollar amount. So just on an apples to apples comparison, Roth versus traditional, if you’re going to be in the exact same tax bracket when you put the money in as when you take the money out, there is no difference, just looking at what are the overall returns.
Now, if I am in a higher tax bracket, let’s say I’m up at the 35% bracket now and I think that I’ll be in the 22% bracket when I retire, and I start taking the money out, this is where you start to see the difference. Because if I’m in that higher bracket now, that means if I put $6,000 into a Roth IRA, I had to pay tax at 35% on that income that I could have deducted had I done the traditional. That would mean that when I get my tax-free distribution 20 years down the road, I’d get $15,092. And that would be if I stay in that 35% bracket. However, if I was in the 22% bracket and I chose to do the traditional IRA, instead of having just $15,000, I would actually have, after tax, $18,000 available to me because of that difference in those tax brackets. That’s a $3,000 difference on $6,000 invested over 20 years. Again, annually compounded at 7%. And it works the other way. If I choose a lower tax bracket going in and a higher tax bracket coming out, then, excuse me, very clearly the advantage goes to the Roth IRA. Whereas the higher tax bracket today goes to the advantage of the traditional IRA.
Now, this is a common understanding. The challenge is, how do we apply it? Because if I’m looking down the road and thinking I’m not gonna need this retirement money for 10, or 20, or 40 years down the road, how in the world do I know what tax bracket I will be in then? Who knows what the most recent election will have brought in terms of Republican versus Democrat and, you know, opinions about if taxes should go up or if taxes should go down, what may or may not get proposed, what may or may not get actually passed and put into law and put into effect in terms of our taxes? Within the last few years we had a very significant change to the tax code, and that could continue to change. And so people will sit back and say, “I just don’t know what to expect. I don’t know what life is gonna bring me. My tax bracket may go up, it may go down. Just no way to know.” So let me give you just a couple of perspectives to consider as you’re thinking about the Roth versus the traditional.
The first one is that if you’re truly investing this money for retirement, one of the big challenges that many struggle with when they get to retirement is that they start to receive their Social Security benefits. And that’s not a struggle, that’s a benefit, it’s there, they paid into the system, they’re receiving that benefit. What a lot of people don’t understand is that if they have other taxable income and it’s too high in those years when they are…especially if they’re over 70 and a half, they’re having to take money out of their traditional IRA accounts and all of those things, it pushes their income up to a place where the IRS actually taxes the Social Security benefit that you’re getting. And when they do that, they’ll actually go up to where 85% of your Social Security benefit becomes taxable at whatever your tax rate it. That is a really, really painful outcome and something that people like to avoid. And it is something that, if you choose Roth, any money that you take out of your Roth IRA once you’re retired, it does not count as income because you don’t have to pay income tax on it, so it doesn’t count as income and so it doesn’t impact the potential taxation of your Social Security benefit. And that can be worth literally thousands of dollars a month or, I’m sorry, a year. It depends on how much your benefit is. It could be, you know, $5,000…up to $10,000 potentially of benefit that you can gain there a year.
Another thing to consider is that Roth IRA money is a lot easier to inherit than traditional IRA money. A traditional IRA is, if you die, you would have indicated who your heirs are or who your beneficiaries are. That money would then be given to them and they could keep it in a similar account. But inherited IRAs, there is a requirement to have to withdraw a certain amount of that money every year and create taxable income, which may or may not be a good situation for your heirs. I mean, if they’re not making much money and they’re in a low tax bracket, it probably is a great idea. But if they happen to be in higher tax brackets, that can be very, very painful to be forced to realize this income as opposed to keeping it away and letting it continue to grow and invest and everything that goes with that. And so the Roth IRA is treated very differently in that as long as it’s been set up and it passes, you know, all the requirements, money that’s going to pass to heirs actually flows through, meaning I just inherited a Roth IRA, and this Roth IRA now allows me because it qualifies and meets all the requirements, I can take all that money out tax-free. So there’s a very interesting benefit there to consider.
The last thing that I just wanna share that I hope will be helpful to you. One way to try to plan for and to protect yourself against these different tax brackets and what if taxes go up, what if they go down, and that means, you know, I may have made a bad choice here or a great choice here, but then it could change somewhere down the road, create a net worth that is diversified in terms of its taxation. So think about this. When you retire, let’s say half of your money is in a Roth IRA and the other half is in a traditional IRA. And it’s time for you to need to start taking money out in order to live. Well, if you have the choice and let’s say that taxes happen to be very, very high at that time, well, you could start to pull money out of your Roth IRA and leave money over in your traditional IRA. Now once you hit 70 and a half, you’ll be required to take minimum required distributions. But there are some cool techniques and strategies to try to manage that and mitigate the tax liability, you know, at least as much as possible and, you know, all within what the tax code allows. But it’s a really interesting strategy to be diversified so that you’re not having to create so much taxable income that you’re putting yourself in a high tax bracket in retirement when the tax landscape may have changed. So by having a diversified set of net worth and being able to then pull on those assets, the ones that make the most sense from a taxation perspective for you at that time gives an interesting type of flexibility going into retirement.
And so the ultimate takeaway here that I want you to have is, first of all, understand what the difference is between the Roth and the traditional IRA option, understand that it has everything to do with your tax bracket today versus the one that you’ll be in when you need to start liquidating or taking money out of this investment vehicle that you’ve started, and that sometimes having some in both can be the best way to diversity yourself against tax risk and potential tax liability in the future.
Well, I hope this has been helpful. I hope it gives you a little bit more clarity as you’re thinking about which one you should pick, which one you should do. And the other thing is, if you’ve funded a traditional IRA for the last many years and you’ve heard this and you like the idea of Roth, then you can start funding a Roth IRA in your next eligible year and you can start putting money there. Or vice versa, if you’ve been doing the Roth but you think, “Wow, maybe I should put some over into the traditional,” each year you have a choice. You can’t do both. You can pick one or the other. And it is also somewhat dependent on if you have an employer-sponsored plan and what you’re contributing to that. And I do plan in my next episode to jump into the discussion about how to set up a 401(k) and how to make sure that you’re thinking through all the things so that that gets set up correctly and is hopefully gonna create the best benefit for you as possible.
Again, I hope there’s a great takeaway for you, understanding a little bit more about this world of IRAs, and it’ll give you a little bit more confidence going into your decision-making process and your financial planning process as all of us are working to try to build our net worth. Many, many thanks to you for joining today. This is a wrap for episode 82. Happy day.
