Transcription
In the realm of retirement planning, there's a wealth of questionable advice circulating about the choice between a traditional IRA and a Roth IRA. Sometimes even seasoned financial advisors often overlook critical factors when helping individuals make this decision.
In this video, the aim is to shed some light on some of these often neglected yet vital aspects, allowing you to make a more informed decision. I will guarantee you that this decision is not quite as simple as determining whether your federal taxes will be higher or lower in retirement.
So, whether you are new to understanding the differences between these types of retirement accounts or believe you have a firm grasp of the concepts, I believe everyone will have a few "aha" moments and pick up some unique tax strategies you probably have not considered.
Let's start with the fundamental distinction between these two types of retirement accounts. In a traditional IRA, IRA just stands for Individual Retirement Account. You make contributions with pre-tax dollars, meaning you don't have to pay income tax on the money you invest each year.
However, when you eventually retire and begin withdrawing the funds from your account, the amount you take out annually becomes taxable income. In essence, you are in partnership with the government through your traditional IRA. You defer taxes now, but you owe them when you withdraw the investments in retirement. Part of your balance belongs to them.
In a Roth IRA, the tax dynamics are reversed. Contributions are made with after-tax dollars, meaning you pay income tax upfront before investing. However, as your investments grow over time and you decide to withdraw the money during retirement, none of it is subject to taxation, regardless of the amount you withdraw each year. The entire balance remains entirely tax-free.
Now, there are other distinctions between the two and several often overlooked factors that demand our consideration. But before jumping into those, let's examine an example of how the taxation operates in practice, and this may even surprise you.
Let's say someone deposits $6,500 of their gross earnings into their traditional IRA. In this case, they don't have to pay taxes on that money that year. If we project the investment grows at an 8% compounded annual growth rate for 32 years, that single deposit of $6,500 would have grown into $76,214 at retirement.
In contrast, with a Roth IRA, someone wishing to deposit the same $6,500 of their gross earnings must first pay income tax on that sum. Let's say this person falls into the 22% marginal federal tax bracket. In that case, they would deduct 22% from the $6,500, leaving them $5,700 to invest in after-tax dollars.
Over that same 32-year period, growing at the same 8% rate, this amount would accumulate to $59,512, all of which is now income tax-free. Now notice that when a person pulls $76,214, the tax rate on that amount means what remains for them is precisely equivalent to the amount in the Roth account, $59,512.
Then you are currently in opting for the traditional IRA makes sense. If you find yourself in a lower tax bracket while working, a Roth IRA may be preferable. But this oversimplified advice disregards several essential factors we need to explore since much of this belief is based on flawed assumptions.
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Okay, now back to the info. In the previous example, both were based on someone that used $6,500 of their earned income before income taxes, but after income taxes, only $5,700 went into the Roth. They both ended up with exactly the same amount once taxes were applied to the traditional account in retirement.
However, if you compare two individuals maxing out their traditional IRA and one maxing out their Roth IRA, both at $6,500, the two accounts, assuming they were invested the same, would grow into the same total, but the Roth account would be tax-free.
The person maxing out the Roth account is kind of tricking themselves into actually investing more of their yearly earnings. Why? Well, to contribute $6,500 into a Roth, it would require $8,333 of earnings before paying the 22% tax in income taxes. So they had $6,500 left to invest.
Thus, if both are maxing out their IRAs, the person doing the Roth will come out way ahead simply because they were actually investing more of their yearly income. Both accounts have a contribution limit of $6,500 in 2023, and if you are over 50, you can put an extra $1,000 in, making the total contribution $7,500.
Just remember that the IRS adjusts all these limits as the years go by, so if you're watching this video after 2023, check the current limits for all the figures mentioned. Also, you can actually do both a Roth IRA and a traditional IRA in the same year, but you can't put $6,500 in each. The total contribution across all IRAs cannot exceed $6,500 for those under 50.
Before we explore additional differences between these two types of accounts and the qualifications you must meet to benefit from them, let's get right into the additional factors you should consider when choosing between them and some of the unique tax strategies.
Let's first consider some factors that swing the pendulum towards preferring a Roth account. Although conventional wisdom suggests that gross earned income declines in retirement, taxable income doesn't always follow suit.
One huge benefit of a Roth IRA, and other Roth-type retirement accounts like a Roth 401(k), is the potential to minimize capital gains taxes. Suppose you own stocks in a personal brokerage account. In that case, when you sell some of those stocks to access that money in retirement, you are subject to capital gains tax, not income tax.
Currently, in 2023, a married couple can have taxable types of income up to $89,250 and pay zero capital gains tax. A single person can have earnings of up to $44,625 and be in the zero capital gains bracket. A traditional retirement account can potentially push your taxable income higher, especially when Social Security gets added to it, and impose capital gains taxes on other assets that might otherwise have remained at zero.
That can be a big deal for some people. Also, if you have saved aggressively and have a nest egg built up allowing you to retire earlier, you get penalized for taking money out of a traditional retirement account if you take it out before the age of 59 and a half.
However, if money is in a Roth-type retirement account, you can take the amount of money you have contributed out at any time without any penalties. Remember that any money pulled out of a Roth account in retirement does not get added to your income at all, and it's always income tax-free.
If our income is low enough, we won't pay income tax on our Social Security benefits either. However, if you only have traditional types of retirement accounts, then what we pull out gets included in our total income. This could cause a portion of our Social Security benefits to be subject to federal income tax.
So, you may be in a slightly lower tax bracket in retirement, but only having traditional accounts can push your Social Security benefits into a taxable range, just as it did with the capital gains taxes.
Also, since Roth accounts allow us to stay in a lower tax bracket, this can affect what you will pay for Medicare Part B. As your income goes up, so does the cost of your monthly premiums that you are forced to pay.
Here's another consideration: if you have saved and invested for retirement and have amassed a sizable nest egg, much of which is in a traditional 401(k) or traditional IRA, you will face mandatory withdrawal requirements once you reach the age of 73 under the current laws.
Let's say you have a nice balance of $3 million in traditional types of retirement accounts, and you're in your mid-70s. Your mandatory withdrawal can easily be over $120,000 in a year. Factor in Social Security and any other types of income, such as dividends, interest, pensions, and you might find yourself in a higher tax bracket in retirement.
This can be a real problem for super savers and would definitely impose taxes on capital gains and any Social Security. Once you retire, you will most likely stop contributing to traditional retirement accounts, so you'll end up losing that deduction.
Okay, now it seems that there are so many reasons why Roth dominates, but here's a little potential benefit of a traditional account. While projecting future income tax rates, don't forget to consider state income taxes.
Currently, Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming don't have state income tax. But if you're working in a high tax state like California, Hawaii, New Jersey, Oregon, Minnesota, and several others, and you are considering relocating to a state with lower or no income tax, that can certainly help lower your taxes in retirement.
Plus, in almost all cases, state income taxes kick in at a lower income threshold compared to federal taxes, potentially impacting a more significant portion of your income. These considerations can help swing the pendulum towards the traditional IRA a bit.
As you see, there's a variety of tax strategies to consider. The decision isn't as straightforward as comparing your current income tax rate with anticipated retirement rates. Your choice may influence whether other types of income sources become taxable, like Social Security and capital gains taxes.
Having a mix, including Roth-type accounts, can help you keep your overall income in a lower tax bracket, potentially reducing the tax burden on other income streams.
Now, since IRAs are a fantastic retirement investment, they come with some restrictions for higher income earners. Let's start with the Roth account. In 2023, a married couple making less than $218,000 or a single person making less than $138,000 in modified adjusted gross income can contribute the full amount of $6,500 and an extra $1,000 if you're over 50.
For married couples making between $218,000 and $228,000, or for a single person making between $138,000 and $153,000, the amount you can contribute starts to get phased out, and you can only contribute a reduced amount. After $228,000 for a married couple or $153,000 for a single person, they can't contribute directly to a Roth account at all.
Again, these limits get adjusted slightly up each year, so if you're watching this after the year 2023, check the current limits.
For a traditional IRA, anyone can contribute regardless of your income. However, whether that contribution ends up being a taxable deduction or not depends on your income. In general, the income limits are similar to those of a Roth but a bit more complicated because they are based both on your income and any participation in employee-sponsored plans.
If the contribution isn't tax-deductible, there isn't much benefit to a traditional IRA. In a Roth IRA, you can withdraw your contributions at any time without any penalties, limited to the amounts you have deposited.
Though any earnings that you might have accumulated along the way must be taken out after the age of 59 and a half, and the account must have been opened for at least five years to avoid a 10% penalty.
With a traditional IRA, you will pay income taxes on any amount you withdraw, and you will also pay the 10% penalty if you take it out before 59 and a half. There are a few exceptions to these penalties. For example, both accounts have options for you to withdraw $10,000 to cover first-time home buyers' expenses, and some qualified education and even some hardship withdrawals are available.
But in general, you want to view these as off-limits; they are for your future security. With a Roth account, there are not any mandatory withdrawal rules of any kind. If you don't need the money, you can continue to allow it to grow.
However, with a traditional account, you must start taking distributions at the age of 73 for people born between 1951 and 1959, and at age 75 for anyone born after 1960.
I'd like to add one other personal thought. While trying to predict the future is a bit of a fool's game, I do feel the tax structure will very likely be higher in the future for most all income levels than what we are experiencing today.
Our government continues to spend money at a concerning rate, and the national debt keeps increasing at alarming rates. More of our budget continues to go to interest on the debt we have accumulated, and we have looming unfunded pension problems.
Having some tax-free money in retirement accounts might turn out to be very advantageous for us since the government can't control their spending problems. The risk of higher taxes on everyone in the future seems pretty likely down the road.
This consideration is another plus for Roth accounts. As you can see, there are numerous factors to consider. If you need help, you might want to talk to a good CPA to look over your personal situation.
Regardless of your choice, setting up an IRA at a place that offers low-cost investment options like ETFs can be very beneficial. I always recommend broker firms like Charles Schwab, Fidelity, and Vanguard, which are all great choices for individual investors.
I hope you found this video valuable and gained some fresh insights you may not have previously considered. As always, thank you for watching. If you're not already, I hope you subscribe and leave some comments below.