RPF0303-Roth_vs_Traditional_Taxation
00:00:00.000 | It's the gentle warmth of the northeast Florida sun and the whisper of an ocean breeze along 13
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00:00:25.040 | your one-of-a-kind Florida beach escape now at AmeliaIsland.com. In arguing whether you should
00:00:32.880 | open a Roth IRA or fund a traditional IRA, have you ever heard or proffered this argument?
00:00:40.240 | Well, you'll pay less tax with the Roth IRA, so you should do that. Ever heard that one? Or worse,
00:00:48.240 | ever made that one? It's myth-busting day on Radical Personal Finance, and today we're just
00:00:53.360 | going to tackle this simple little question with a calculator. Welcome to the Radical
00:01:14.080 | Personal Finance podcast. My name is Joshua Sheets. I'm your host. Thank you for being
00:01:19.440 | here with me today as we work on building a rich life now and a plan for financial freedom
00:01:24.720 | in 10 years or less. Going to keep today's show tightly focused on this myth. I'm ashamed to say
00:01:34.640 | that I used to spread this one. This is one of those common, common themes. There's a constant
00:01:49.120 | debate about Roth IRA versus traditional IRA. Roth IRA versus traditional IRA goes around
00:01:55.600 | and around and around and around, and rightly so because it is a big decision. Now, to put it in
00:02:01.120 | perspective, recognize that it's really not that big of a decision for many people. You're capped
00:02:06.400 | at, what, five grand-ish, depending on what year you're listening to this for your contributions
00:02:12.960 | to a Roth IRA. So for some people, that can be a substantial portion of your income, but for many
00:02:18.880 | people, it's just not that much. But let's wade into it a little bit, and I want to keep tightly
00:02:24.640 | focused on one issue, which is simply the issue of the math. So if you are not familiar with the
00:02:33.040 | basic taxation of a traditional IRA versus a Roth IRA, it works like this. In a traditional IRA,
00:02:40.560 | and it's the same also in a 401(k) or other types of accounts that have the same taxation,
00:02:46.800 | we're just going to stay today with the term traditional IRA. In traditional IRA, you earn
00:02:51.680 | a dollar, and you're able to contribute that dollar to your account before you pay income tax.
00:02:58.000 | So if you earn a dollar, you get to put the whole thing in there, and you fund your account with a
00:03:03.200 | dollar. And then that money grows over time until it comes to the point of distribution,
00:03:09.280 | at which you go ahead and pay your taxes. But now you pay taxes on the whole amount of the account
00:03:15.760 | instead of just on the initial dollar. If you compare and contrast that to a Roth IRA,
00:03:21.760 | a Roth IRA works like this. You earn a dollar, and you pay taxes on the dollar.
00:03:25.840 | Let's say that you're paying taxes at an effective tax rate of 30%. So 30 cents out of your dollar
00:03:31.680 | goes to the government. 70 cents gets contributed into the account. That 70 cents grows.
00:03:41.760 | When you go to retire and are planning to make your distribution from the account,
00:03:46.560 | at that point in time, you get to spend all of the money without paying income taxes on it.
00:03:53.520 | So whatever the balance of the account is at retirement age,
00:03:57.520 | you can spend all of that money with no taxes due. So in which of those scenarios
00:04:06.000 | do you spend less money on tax? Most people intuitively would say the Roth IRA.
00:04:14.480 | And I've probably baited you sufficiently that you were slow to answer in your mind,
00:04:19.600 | but I used to say the Roth IRA. And by the way, to my own shame, I used to say the Roth IRA
00:04:26.560 | after I was a professional licensed financial advisor, giving financial advice. I had never
00:04:34.720 | sat down and done this math. And then one day I sat down in my managing director's office,
00:04:40.320 | and we were talking about this question. He's like, "You do know that they're exactly the same?"
00:04:44.880 | I said, "No." He said, "Yes, they're exactly the same." And we did some math, and I tell you,
00:04:51.280 | I felt like a fool because here I was supposed to know what I'm talking about. And here I am
00:04:57.280 | perpetuating this myth on unsuspecting people. Thankfully, I didn't perpetuate it on too many
00:05:03.520 | people, but I did. So let's do a little bit of math, and let's keep it simple, because I think
00:05:09.600 | this is important to recognize. A lot of people get bogged down with the tax question when they
00:05:15.120 | are focusing on this, and they need to be looking at other factors, which is going to be where we'll
00:05:19.280 | go after I demonstrate this math to you. Let's do Roth math first. Bump it up from a dollar.
00:05:26.000 | Bump it up from a dollar. Let's say that you earn $10,000, and between a dual-income household,
00:05:33.440 | you can contribute $10,000 to a couple of Roth IRAs. Assume that you are at a 25%
00:05:39.440 | effective tax bracket. This will help us keep math nice and simple. 25% effective tax bracket.
00:05:47.520 | That means that you earn $10,000, and you pay $2,500 in taxes, leaving you with $7,500
00:05:57.600 | to invest in the account. Assume that you keep that money invested for a total of 10 years. I'm
00:06:04.480 | going to use nice round numbers, not making any statements about what you invest in, just using
00:06:09.120 | some round numbers to illustrate the point. So you invest the money for 10 years, and assume that
00:06:14.480 | your annual rate of return after taxes and expenses is 10%. Again, round numbers to illustrate a point.
00:06:22.960 | At the end of your 10 years of investing, that $10,000 would have grown to be $19,453.07.
00:06:33.120 | So that means because you invested using a Roth IRA, you can spend $19,453.07.
00:06:44.080 | You paid your taxes up front. Again, if you're listening in the car, I'll repeat the numbers.
00:06:49.280 | You earn $10,000. You are in a 25% effective tax bracket. You pay $2,500 in taxes, allowing you to
00:06:56.800 | invest $7,500 in the account. $7,500 invested today in one lump sum at a 10% annual rate of
00:07:04.400 | return for 10 years would come out to be $19,453.07 at the end of the term. We're assuming that
00:07:11.280 | you can distribute the money after your age of retirement, 59 and a half. We're assuming no
00:07:16.800 | penalties here in either scenario. We're also assuming that you're in the same tax bracket,
00:07:20.640 | 25%. That means that you can spend $19,453.07 at retirement.
00:07:26.880 | Now, let's compare that to a traditional IRA. In a traditional IRA, you're able to earn $10,000,
00:07:35.840 | but you invest all of it before paying any income tax. That means that you have the full $10,000
00:07:45.200 | available as an investment. Invest that money in a lump sum at a 10% annual rate of return,
00:07:50.320 | net of taxes and fees, for 10 years, and you wind up with $25,937.42 at the end of the term.
00:08:01.840 | Much more. But remember now, you have that embedded tax liability. You have to pay 25%
00:08:09.360 | of that in taxes, which leaves you with $19,453.07 to spend in retirement.
00:08:17.920 | Exactly the same number as the Roth. This is very important because many people begin their
00:08:27.680 | analysis of what to do, which type of account to use, with the mistaken assumption that the
00:08:32.720 | taxation is going to be different simply because they chose a Roth versus a traditional IRA.
00:08:39.120 | If you are in the same tax bracket during your working lifetime,
00:08:43.280 | and if tax rates are the same during your working lifetime as they are after retirement,
00:08:49.200 | you will pay the identical amount percentage-wise of income tax.
00:08:56.560 | Now, are there other extenuating factors? Yes, there are tons of them, tons of assumptions. So,
00:09:00.960 | for example, in the beginning of the show, I said, "You're going to pay the same amount of tax." Well,
00:09:05.600 | you'll pay the same amount of tax when expressed as a percentage, but you will not pay the same
00:09:10.720 | amount of tax when expressed as a dollar value. In the first example, you pay $2,500 of tax,
00:09:19.600 | and in the second example, if I can do the math real quick, $25,937.42 and pull out $19,453.07.
00:09:28.880 | In the second time, you'll pay $6,484.35 of total tax. So, your total tax that you're paying
00:09:36.640 | will be very different, but the amount of your tax, excuse me, the percentage amount of your
00:09:41.440 | tax will be identical if your tax rate and tax bracket rates are the same.
00:09:47.600 | So, when making this analysis, you cannot make the analysis simply on the basis of which is cheaper,
00:09:59.840 | because they have the same net cost. You must make the analysis based upon other factors,
00:10:06.960 | and there are three major ones, and the third one is kind of a catch-all, so forgive me,
00:10:10.800 | but I just put them into three major ones. Number one, you have to make a judgment or a guess
00:10:17.120 | about tax rates in general, tax brackets, generalized tax brackets for the population.
00:10:25.280 | Do you expect tax brackets to be higher, to be lower? Do you expect tax brackets to be progressive,
00:10:32.880 | increasing, or flat? Do you expect tax brackets to change or to stay consistent? So, you've got
00:10:42.000 | to make a guess about tax brackets in general and tax rates for the general population.
00:10:47.920 | You also have to make a guess regarding your specific tax rates.
00:10:53.360 | So, do you anticipate earning more income in the early years or in the later years, because your
00:11:01.920 | specific tax rate will be judged, will be based upon the income that you're earning. Are you going
00:11:06.720 | to be making more during your working lifetime or at the end in retirement? You have to guess at that.
00:11:14.880 | And finally, you have to factor in my point, my factor number three is what I call other factors,
00:11:23.440 | meaning you have to factor in the other features of the type of account that you choose. Simple
00:11:29.440 | example, in a Roth IRA, you can make a distribution of your contributions to the account at any time
00:11:35.760 | with no penalties or taxes due. So, if you contribute $5,000 to the account and next year
00:11:41.680 | you need $5,000, you can take the $5,000 right out. So, that's a little bit more flexible.
00:11:47.600 | And the reason you can do it is because you've already paid the money on the tax. You can't
00:11:52.080 | touch the earnings without penalties, but you can touch the contributions.
00:11:58.960 | Another factor might be something like a required minimum distribution.
00:12:03.360 | A Roth IRA under current tax law does not have a required minimum distribution.
00:12:07.520 | A traditional IRA would. Other types of accounts would. You also have to make decisions based upon
00:12:14.160 | your total income. Some people are eligible for IRAs that are deductible. Some people are eligible
00:12:19.280 | for Roth IRAs. Some people aren't. So, you've got to use those specific examples, and that's why we
00:12:25.360 | go into so much detail about these types of accounts. But to start with, you have to recognize
00:12:30.320 | that the math on them is exactly the same. Now, am I going to tell you what to do? Not really.
00:12:35.040 | I'll tell you, the arguments you'll hear on all these different factors are many, and I think
00:12:41.600 | there are some good ones. The standard question that you hear today is, "Well, which direction do
00:12:47.760 | you think tax rates are going to go?" And the expected response, usually it's treated as a
00:12:52.560 | rhetorical question, the expected response is, "Well, they're going to go up because we have
00:12:57.200 | all this government debt." I tell you, I can see that argument. Personally, I'm not persuaded of
00:13:03.600 | it anymore. I'm not persuaded of it since reviewing the charts demonstrating that
00:13:09.120 | effective tax rates in general are actually pretty consistent over the last 70 years.
00:13:15.920 | They really don't ever exceed 20% of GDP. So, I think that although there's a lot of political
00:13:22.480 | rhetoric around the increase of tax brackets, I don't think there's any political ability of
00:13:27.920 | somebody to actually affect it. If you look at the changing tax rates, even by those who want to
00:13:33.520 | increase taxes, in the aggregate, they're pretty minimal. So, I don't know that I particularly buy
00:13:38.800 | the argument about tax brackets changing in general, but I see the point. I don't know.
00:13:44.320 | Your guess is as good as mine on that. How is it possible to make a political calculation about the
00:13:50.240 | political will of a large body of hundreds of millions of people who all have diverse interests,
00:13:56.240 | perspectives, and desires? I don't know. Your specific tax rates, that's a little bit more
00:14:03.200 | predictable, but it's very subjective to your plan. It's very subjective to your approach to life.
00:14:14.080 | Most people will be earning much more during the working lifetime than in the retirement years.
00:14:20.960 | That's what the data that I've reviewed indicates to me. That's why you'll find
00:14:27.360 | many financial advisors will usually recommend that it's better for you to do a deductible
00:14:32.960 | upfront option, because it's tough to accumulate enough money where your retirement income is
00:14:38.720 | going to be so high that you are going to be in a higher bracket in retirement. It's tough.
00:14:47.280 | Is it possible? I don't know. I've tried to run some scenarios. I've never been satisfied with
00:14:52.160 | them enough to publish them. But of course, it's possible if you have excellent investments and
00:14:58.080 | you just become wealthier and wealthier every year. But if you just consider the mainstream
00:15:02.880 | median scenario, middle-class, median income earners who are working, if you think about it,
00:15:09.840 | many times a family is working hardest in their young years, lots of expenses involving kids,
00:15:15.200 | lots of expenses involving large mortgages. Most people are at the highest earnings in those early
00:15:21.920 | years. Most people don't earn more in retirement than they do in working. So most people,
00:15:27.120 | their personal tax rates are going to go down. But is that specific for you? I don't know.
00:15:32.800 | You have to check that one out. I just make you aware that that's going to be the biggest factor.
00:15:37.440 | And there's no perfect answer in the aggregate. It's all subjective. And at some point in time,
00:15:45.040 | you're going to have to make a guess. What about those other factors? As far as I'm concerned,
00:15:50.160 | those other factors are compelling. And what I think is most reasonable is to make an assessment
00:15:57.440 | on an ongoing basis of which type of account you should use. It shouldn't be a standard decision
00:16:05.040 | of you always do this. It should be looking at my situation, my effective tax rate currently,
00:16:12.480 | my prognosis for income changes in the coming years, the usefulness of these assets,
00:16:19.920 | where do I want the money, do I want to have control of the money, etc. That's where all
00:16:24.880 | the other shows we do and will do in the future, which dig into these questions, is very, very
00:16:30.080 | important. But today, I just want to leave you with that very simple math regarding the impact
00:16:35.680 | of tax brackets. For some of you, that may seem old hat, but I guarantee for some of you,
00:16:42.240 | that's the first time you ever had that math done. I know it because that happened to me.
00:16:46.960 | A lot of you like to catch out your financial advisors. That's a fun one to do. I'll bet you
00:16:52.960 | some percentage. I wouldn't say a majority, but I'll bet you some percentage of you,
00:16:56.640 | if you want to have a little fun with your financial advisor, you might be able to catch
00:16:59.440 | them out in a moment of weakness and see if they've ever sat down and done that. You would
00:17:03.760 | have been able to catch me out in the past. So I recommend that to you.
00:17:09.280 | This show came about as a response from an interesting email from a listener of a scenario
00:17:15.440 | that I'd never thought of for early retirement. I'm just going to leave it there with a teaser,
00:17:20.480 | but I've just spent the last hour and a half working on some interesting math of using
00:17:25.760 | traditional IRAs and 401ks for early retirement planning, taking income off of it, even when
00:17:30.720 | incurring the penalty. It's got some interesting results. So I'm still fact-checking it and working
00:17:34.800 | on it, but I'll share that with you in the future. I might have that listener on who brought me the
00:17:37.840 | idea. It was brand new to me. I just say that in closing to say, if any of you guys ever have these
00:17:43.360 | ideas, I'd love to hear from you. One of the greatest things, the benefits that I get doing
00:17:47.760 | this show is I get the benefit of interacting with you guys. I get the benefit of hearing from
00:17:52.400 | the collective intelligence. Many of you are so much more knowledgeable than I am. If you ever
00:17:58.160 | catch me in mistakes or you just have great ideas and you wonder if I've heard about them, please
00:18:02.800 | send them to me. You can always do that, joshua@radicalpersonalfinance.com or just use the
00:18:06.800 | contact form on the website, which is now working. I love hearing from you guys. Thank you so much.
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