The_Ideal_Time_To_Contribute_To_A_Roth_IRA
00:00:00.000 | Hello everybody, it's Sam from Financial Samurai and in this episode I want to talk about the
00:00:04.920 | Roth IRA.
00:00:05.920 | So I was actually talking to my editor at Penguin Random House about the Roth IRA and
00:00:12.360 | the traditional IRA chapter and it made me realize how I missed the boat on contributing
00:00:19.040 | to a Roth IRA and it just reminded me of how I was so myopic in my thinking because when
00:00:25.280 | I first started Financial Samurai it was back in 2009 and I was making a good income and
00:00:30.960 | because I was making a good income I couldn't contribute to a Roth IRA.
00:00:35.680 | For 2021 as a single person you must make under $140,000 to contribute to a Roth IRA
00:00:42.680 | and if you're married and filed jointly your modified adjusted gross income must be under
00:00:47.440 | $208,000 to contribute to a Roth IRA.
00:00:52.380 | So fortunately or unfortunately I wasn't able to contribute to a Roth IRA because my income
00:00:57.680 | back then was higher than the limits and the limits back then were lower.
00:01:01.880 | So I thought to myself well screw the Roth IRA.
00:01:04.880 | I found it to be discriminatory.
00:01:06.880 | Why was there this arbitrary income figure that enabled people to contribute whereas
00:01:12.080 | some people could not?
00:01:13.600 | And I even wrote a post called the disadvantages of the Roth IRA which I'll link to in the
00:01:17.520 | show notes and it just goes through point after point on why you shouldn't contribute
00:01:22.880 | to a Roth IRA.
00:01:24.560 | But again I had a very myopic way of thinking about it because I couldn't contribute.
00:01:28.120 | So if I couldn't contribute well why are other people contributing?
00:01:32.060 | But over time over time I recognized the fallacy in my ways.
00:01:37.080 | I also read through 600 plus comments arguing for and against contributing to a Roth IRA
00:01:44.360 | and I've come around.
00:01:45.360 | I really have.
00:01:46.360 | And if you look through the progress over the years I wrote a post called why I never
00:01:50.560 | contributed to a Roth IRA but why you probably should.
00:01:54.280 | And as a father of two children now I think opening up a custodial Roth IRA is a no brainer.
00:02:01.720 | It is such a no brainer.
00:02:03.120 | I'm recording this podcast to tell you that it is a no brainer.
00:02:06.800 | In the most simple example think about it this way.
00:02:09.760 | If you are a student you can earn twelve thousand five hundred fifty dollars tax free.
00:02:15.680 | Then you can contribute that tax free money up to six thousand dollars in your Roth IRA
00:02:20.680 | and then it can compound over the years over the decades without a tax drag.
00:02:25.960 | And then when you withdraw that money it's tax free.
00:02:29.500 | So to not contribute to a Roth IRA when you're earning income below the standard deduction
00:02:34.680 | amount is foolish.
00:02:37.320 | And if you are earning a salary that doesn't face a high tax rate you should probably contribute
00:02:42.800 | to a Roth IRA.
00:02:44.440 | For most of us as we gain more experience and expertise we're going to make more money.
00:02:49.000 | So that's really logical and therefore we're going to face a higher tax rate.
00:02:52.940 | So contribute to a Roth IRA when you're young when you're inexperienced when you don't make
00:02:58.240 | much money.
00:02:59.720 | Let's go through what the current marginal tax rates are the federal marginal tax rates.
00:03:04.600 | So 10 percent up to nine thousand nine hundred fifty dollars.
00:03:09.160 | Twelve percent from nine thousand nine hundred fifty one to forty thousand five hundred twenty
00:03:13.200 | five.
00:03:14.640 | Twenty two percent from forty thousand five hundred twenty six to eighty six thousand
00:03:19.160 | three hundred seventy five.
00:03:21.560 | Twenty four percent from eighty six thousand three hundred seventy six to one hundred sixty
00:03:26.000 | four thousand nine hundred twenty five.
00:03:28.840 | And after that it's the 32 percent bracket 35 percent and 37 percent tax bracket.
00:03:34.380 | So where is the biggest jump.
00:03:36.360 | The biggest jump is from 12 percent to 22 percent marginal income tax rate.
00:03:41.520 | So when you start making above forty thousand five hundred twenty five up to eighty six
00:03:46.640 | thousand three hundred seventy five.
00:03:48.260 | That is the biggest jump.
00:03:49.740 | The second biggest jump is from 24 percent to 32 percent.
00:03:53.400 | That's an 8 percent jump.
00:03:55.080 | So once you start making over one hundred sixty five thousand basically up to two hundred
00:03:59.640 | nine thousand four hundred twenty five.
00:04:01.960 | You're at 32 percent.
00:04:03.360 | So the question you have to ask yourself is how much of a tax rate you're comfortable
00:04:08.920 | paying up front to the inefficient government so you can earn money tax free.
00:04:14.240 | And what do you think your tax rate will be in retirement.
00:04:17.500 | Well here is some shocking news that I think some people don't believe.
00:04:22.720 | And that is you're probably going to make less money in retirement than while you are
00:04:27.840 | working.
00:04:28.840 | So if you think about that logic that in retirement your income and your marginal tax rate should
00:04:35.120 | be lower than while you were working at least during your middle and high income earning
00:04:38.560 | years.
00:04:39.560 | That's really logical but a lot of people don't see it that way.
00:04:43.500 | A lot of people believe that they will be making even more in retirement than while
00:04:48.000 | working.
00:04:49.000 | Now they've got that mixed up.
00:04:50.000 | I think what they think they mean is they will have more net worth in retirement than
00:04:57.120 | while they were working.
00:04:58.320 | That's logical.
00:04:59.320 | But from the income standpoint it's illogical.
00:05:01.880 | Therefore you need to think about tax differentials while you're working and while you're retired.
00:05:09.680 | And because interest rates have come down basically for the past 40 years it's going
00:05:15.840 | to take a lot more capital to generate more risk adjusted income.
00:05:21.600 | It just simply does.
00:05:22.760 | It takes double the amount of capital to generate the same amount of income from going from
00:05:27.980 | 4% to 2%.
00:05:29.940 | So now that you have this logical framework in mind let's just go back to the federal
00:05:33.160 | marginal income tax rates.
00:05:35.080 | I don't think anybody should spend or pay more than 24% in federal marginal income tax.
00:05:42.520 | Therefore once you make over $165,000 I don't know folks I don't think contributing to a
00:05:49.960 | Roth IRA is a good idea.
00:05:53.000 | Are you really going to feel good paying a 32% marginal income tax rate for your $6,000
00:05:58.520 | contribution to your Roth IRA?
00:06:01.000 | I wouldn't because 32% is just federal.
00:06:03.800 | If you have state it could be another 4% to 7% and that just doesn't feel good to me.
00:06:11.800 | Okay so forget about feeling good and feeling bad.
00:06:14.640 | Let's just run the numbers.
00:06:16.280 | At 32% the marginal tax rate you got to make over about $165,000 up to $209,000.
00:06:23.300 | How much capital is required to generate that type of income in retirement?
00:06:28.900 | Let's just use $200,000 and divide it by 4%.
00:06:32.460 | You need $5 million in capital to generate $200,000.
00:06:37.500 | But how many Americans have $5 million in capital in retirement?
00:06:41.680 | The answer is less than 5% because the top 1% threshold is about $10 million.
00:06:47.080 | Now let's take a more conservative divisor since interest rates have come down and divide
00:06:51.360 | $200,000 by 2%.
00:06:53.420 | Well now you need $10 million in capital to generate $200,000 a year in retirement.
00:06:59.960 | So the reality is I think some people just are not doing the math.
00:07:04.240 | You got to do the math and be realistic with your future net worth assumptions and income
00:07:09.980 | assumptions.
00:07:10.980 | Of course we're going to have social security.
00:07:12.480 | The average social security amount is about $15,000 to $16,000 a year.
00:07:18.040 | And then you would add your investment income in retirement to come up with your estimated
00:07:22.600 | retirement income and marginal tax rate.
00:07:25.720 | And you know what's funny folks?
00:07:27.340 | This exercise on contributing above $165,000 is mute because the government saves us a
00:07:33.640 | little bit.
00:07:34.640 | It saves us by saying only people who make less than $140,000 a year can contribute to
00:07:39.440 | the Roth IRA.
00:07:40.940 | So only people in the 24% marginal tax bracket can contribute.
00:07:46.720 | So when you think about it that way, then it's all about looking at the remaining tax
00:07:51.420 | rates of 10%, 12%, 22%, and 24%.
00:07:55.580 | So I would take it a step further and say, well, once you start making $86,376 a year
00:08:03.040 | or more, that puts you in the 24% tax rate, I don't know if I'd be contributing to a Roth
00:08:08.480 | IRA.
00:08:09.480 | I would just contribute to a Roth IRA if I'm in the 22% or lower marginal income tax rate.
00:08:16.840 | A 22% marginal income tax rate seems quite reasonable.
00:08:21.960 | All in, you're going to have an effective tax rate of probably in the teens with your
00:08:27.200 | federal income tax.
00:08:28.900 | So that's reasonable.
00:08:30.080 | You're keeping four times the amount of money than the government is taking from you.
00:08:34.400 | It seems pretty fair.
00:08:36.080 | Therefore, max out your Roth IRA if you can at those income levels to diversify your retirement
00:08:43.360 | income streams.
00:08:44.640 | So one thing my father who's in his 70s told me was that I wish I contributed more to a
00:08:49.160 | Roth IRA because he's got social security, he's got a pension, and he's got to pay taxes
00:08:55.180 | on those required minimum distributions after age 70, and he's over age 70.
00:08:59.960 | If he had invested in a Roth IRA, even if it's just $6,000 a year contribution for 10,
00:09:06.840 | 20 years, I'm not quite sure exactly what his income was, it would be a really nice
00:09:12.920 | sum of money that he doesn't have to pay tax on.
00:09:15.640 | So it is about diversification of your retirement income sources.
00:09:20.360 | Now obviously, the next part of the equation is the future of marginal income tax rates.
00:09:26.300 | What will they be when we are retired?
00:09:29.240 | The fact of the matter is nobody knows, but we can look at the trend.
00:09:32.120 | The trend is down.
00:09:35.240 | Marginal income tax rates in America have come down from the 70s, 80s, 90s, and it's
00:09:40.920 | been great.
00:09:41.920 | It's been a boon for capitalists.
00:09:44.440 | And given it's been a boom, and given we are all more accustomed to lower marginal income
00:09:50.120 | tax rates, it's really hard to see marginal income tax rates go up a lot for at least
00:09:56.840 | the middle class.
00:09:58.120 | Sure, the top marginal income tax rate is trying to be increased to 39.7% under President
00:10:04.680 | Biden.
00:10:06.000 | Will it happen?
00:10:07.000 | I'm not sure, but even if it does happen, well, less than 5% of the American population
00:10:13.680 | will be affected, so it doesn't really matter.
00:10:15.680 | And then if we're talking about the Roth IRA perspective, it's a middle class retirement
00:10:20.780 | savings vehicle that has an income limit of $140,000 this year, so it really doesn't matter.
00:10:26.860 | In conclusion, I say contribute to your Roth IRA to the maximum if you can, so long as
00:10:32.620 | your income is in the 22% marginal federal income tax bracket or lower.
00:10:38.660 | Now in the future, income tax rates might change, and whatever changes that may happen,
00:10:44.120 | I say continue to contribute to your Roth IRA so long as your marginal income tax bracket
00:10:49.040 | is about 25% lower.
00:10:52.120 | Over 25%, I think it's a gray area, and it's kind of a wash.
00:10:56.100 | Your goal is to contribute as much to your retirement accounts as possible in a tax advantageous
00:11:00.880 | manner.
00:11:01.880 | The Roth IRA is one, the traditional IRA is another, but for pre-tax dollars, I would
00:11:07.240 | try to focus on maxing out your 401(k) every single year.
00:11:11.800 | Do it, make it automatic, and your spending and your budget will adjust accordingly.
00:11:17.060 | I also want you guys to think about the Roth IRA and the 401(k) as kind of funny money.
00:11:23.220 | It's kind of like Social Security.
00:11:24.940 | If it's there for you after the age of 60, then great, but try not to count on it to
00:11:31.740 | live your ideal retirement lifestyle.
00:11:34.400 | You've got Social Security, but more importantly, over the 40 years that you're going to be
00:11:39.060 | working after high school, you're building your taxable portfolio.
00:11:43.900 | Your taxable portfolio is your brokerage accounts.
00:11:46.380 | It can also be your rental property portfolio and other investments, as well as your side
00:11:51.100 | hustle and your business.
00:11:52.740 | These are the investments and assets that are going to generate passive income so you
00:11:57.420 | can reach financial freedom sooner than the traditional 60 plus retirement age.
00:12:02.900 | And if you're happy working until 60 plus, then great, you found that job that provides
00:12:07.560 | you meaning, that provides you some purpose, and that's wonderful.
00:12:11.260 | However, it's always good to think about your retirement income as a diverse portfolio due
00:12:17.160 | to tax liability.
00:12:19.380 | Taxes are our largest ongoing liability.
00:12:22.340 | There's no way around it, but we can be smart about things and we can diversify.
00:12:25.700 | So if you have any thoughts about the Roth IRA, I'd love to hear it.
00:12:30.260 | I've definitely changed my tune over the years, especially now that I'm a father.
00:12:34.980 | And that's one of the most important things in personal finance, being flexible in thought,
00:12:39.300 | being open to new ideas and new perspectives, and to just try to keep an open mind when
00:12:44.260 | you hear something that might not sound quite right.
00:12:47.340 | But the reality is it could be right for that person.
00:12:50.200 | So thanks so much and if you enjoyed this episode, I'd love a positive review.
00:12:54.400 | Take care folks.