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Ever heard that one? Or worse, ever made that one? It's myth-busting day on Radical Personal Finance, and today we're just going to tackle this simple little question with a calculator. Welcome to the Radical Personal Finance podcast. My name is Joshua Sheets. I'm your host. Thank you for being here with me today as we work on building a rich life now and a plan for financial freedom in 10 years or less.

Going to keep today's show tightly focused on this myth. I'm ashamed to say that I used to spread this one. This is one of those common, common themes. There's a constant debate about Roth IRA versus traditional IRA. Roth IRA versus traditional IRA goes around and around and around and around, and rightly so because it is a big decision.

Now, to put it in perspective, recognize that it's really not that big of a decision for many people. You're capped at, what, five grand-ish, depending on what year you're listening to this for your contributions to a Roth IRA. So for some people, that can be a substantial portion of your income, but for many people, it's just not that much.

But let's wade into it a little bit, and I want to keep tightly focused on one issue, which is simply the issue of the math. So if you are not familiar with the basic taxation of a traditional IRA versus a Roth IRA, it works like this. In a traditional IRA, and it's the same also in a 401(k) or other types of accounts that have the same taxation, we're just going to stay today with the term traditional IRA.

In traditional IRA, you earn a dollar, and you're able to contribute that dollar to your account before you pay income tax. So if you earn a dollar, you get to put the whole thing in there, and you fund your account with a dollar. And then that money grows over time until it comes to the point of distribution, at which you go ahead and pay your taxes.

But now you pay taxes on the whole amount of the account instead of just on the initial dollar. If you compare and contrast that to a Roth IRA, a Roth IRA works like this. You earn a dollar, and you pay taxes on the dollar. Let's say that you're paying taxes at an effective tax rate of 30%.

So 30 cents out of your dollar goes to the government. 70 cents gets contributed into the account. That 70 cents grows. When you go to retire and are planning to make your distribution from the account, at that point in time, you get to spend all of the money without paying income taxes on it.

So whatever the balance of the account is at retirement age, you can spend all of that money with no taxes due. So in which of those scenarios do you spend less money on tax? Most people intuitively would say the Roth IRA. And I've probably baited you sufficiently that you were slow to answer in your mind, but I used to say the Roth IRA.

And by the way, to my own shame, I used to say the Roth IRA after I was a professional licensed financial advisor, giving financial advice. I had never sat down and done this math. And then one day I sat down in my managing director's office, and we were talking about this question.

He's like, "You do know that they're exactly the same?" I said, "No." He said, "Yes, they're exactly the same." And we did some math, and I tell you, I felt like a fool because here I was supposed to know what I'm talking about. And here I am perpetuating this myth on unsuspecting people.

Thankfully, I didn't perpetuate it on too many people, but I did. So let's do a little bit of math, and let's keep it simple, because I think this is important to recognize. A lot of people get bogged down with the tax question when they are focusing on this, and they need to be looking at other factors, which is going to be where we'll go after I demonstrate this math to you.

Let's do Roth math first. Bump it up from a dollar. Bump it up from a dollar. Let's say that you earn $10,000, and between a dual-income household, you can contribute $10,000 to a couple of Roth IRAs. Assume that you are at a 25% effective tax bracket. This will help us keep math nice and simple.

25% effective tax bracket. That means that you earn $10,000, and you pay $2,500 in taxes, leaving you with $7,500 to invest in the account. Assume that you keep that money invested for a total of 10 years. I'm going to use nice round numbers, not making any statements about what you invest in, just using some round numbers to illustrate the point.

So you invest the money for 10 years, and assume that your annual rate of return after taxes and expenses is 10%. Again, round numbers to illustrate a point. At the end of your 10 years of investing, that $10,000 would have grown to be $19,453.07. So that means because you invested using a Roth IRA, you can spend $19,453.07.

You paid your taxes up front. Again, if you're listening in the car, I'll repeat the numbers. You earn $10,000. You are in a 25% effective tax bracket. You pay $2,500 in taxes, allowing you to invest $7,500 in the account. $7,500 invested today in one lump sum at a 10% annual rate of return for 10 years would come out to be $19,453.07 at the end of the term.

We're assuming that you can distribute the money after your age of retirement, 59 and a half. We're assuming no penalties here in either scenario. We're also assuming that you're in the same tax bracket, 25%. That means that you can spend $19,453.07 at retirement. Now, let's compare that to a traditional IRA.

In a traditional IRA, you're able to earn $10,000, but you invest all of it before paying any income tax. That means that you have the full $10,000 available as an investment. Invest that money in a lump sum at a 10% annual rate of return, net of taxes and fees, for 10 years, and you wind up with $25,937.42 at the end of the term.

Much more. But remember now, you have that embedded tax liability. You have to pay 25% of that in taxes, which leaves you with $19,453.07 to spend in retirement. Exactly the same number as the Roth. This is very important because many people begin their analysis of what to do, which type of account to use, with the mistaken assumption that the taxation is going to be different simply because they chose a Roth versus a traditional IRA.

If you are in the same tax bracket during your working lifetime, and if tax rates are the same during your working lifetime as they are after retirement, you will pay the identical amount percentage-wise of income tax. Now, are there other extenuating factors? Yes, there are tons of them, tons of assumptions.

So, for example, in the beginning of the show, I said, "You're going to pay the same amount of tax." Well, you'll pay the same amount of tax when expressed as a percentage, but you will not pay the same amount of tax when expressed as a dollar value. In the first example, you pay $2,500 of tax, and in the second example, if I can do the math real quick, $25,937.42 and pull out $19,453.07.

In the second time, you'll pay $6,484.35 of total tax. So, your total tax that you're paying will be very different, but the amount of your tax, excuse me, the percentage amount of your tax will be identical if your tax rate and tax bracket rates are the same. So, when making this analysis, you cannot make the analysis simply on the basis of which is cheaper, because they have the same net cost.

You must make the analysis based upon other factors, and there are three major ones, and the third one is kind of a catch-all, so forgive me, but I just put them into three major ones. Number one, you have to make a judgment or a guess about tax rates in general, tax brackets, generalized tax brackets for the population.

Do you expect tax brackets to be higher, to be lower? Do you expect tax brackets to be progressive, increasing, or flat? Do you expect tax brackets to change or to stay consistent? So, you've got to make a guess about tax brackets in general and tax rates for the general population.

You also have to make a guess regarding your specific tax rates. So, do you anticipate earning more income in the early years or in the later years, because your specific tax rate will be judged, will be based upon the income that you're earning. Are you going to be making more during your working lifetime or at the end in retirement?

You have to guess at that. And finally, you have to factor in my point, my factor number three is what I call other factors, meaning you have to factor in the other features of the type of account that you choose. Simple example, in a Roth IRA, you can make a distribution of your contributions to the account at any time with no penalties or taxes due.

So, if you contribute $5,000 to the account and next year you need $5,000, you can take the $5,000 right out. So, that's a little bit more flexible. And the reason you can do it is because you've already paid the money on the tax. You can't touch the earnings without penalties, but you can touch the contributions.

Another factor might be something like a required minimum distribution. A Roth IRA under current tax law does not have a required minimum distribution. A traditional IRA would. Other types of accounts would. You also have to make decisions based upon your total income. Some people are eligible for IRAs that are deductible.

Some people are eligible for Roth IRAs. Some people aren't. So, you've got to use those specific examples, and that's why we go into so much detail about these types of accounts. But to start with, you have to recognize that the math on them is exactly the same. Now, am I going to tell you what to do?

Not really. I'll tell you, the arguments you'll hear on all these different factors are many, and I think there are some good ones. The standard question that you hear today is, "Well, which direction do you think tax rates are going to go?" And the expected response, usually it's treated as a rhetorical question, the expected response is, "Well, they're going to go up because we have all this government debt." I tell you, I can see that argument.

Personally, I'm not persuaded of it anymore. I'm not persuaded of it since reviewing the charts demonstrating that effective tax rates in general are actually pretty consistent over the last 70 years. They really don't ever exceed 20% of GDP. So, I think that although there's a lot of political rhetoric around the increase of tax brackets, I don't think there's any political ability of somebody to actually affect it.

If you look at the changing tax rates, even by those who want to increase taxes, in the aggregate, they're pretty minimal. So, I don't know that I particularly buy the argument about tax brackets changing in general, but I see the point. I don't know. Your guess is as good as mine on that.

How is it possible to make a political calculation about the political will of a large body of hundreds of millions of people who all have diverse interests, perspectives, and desires? I don't know. Your specific tax rates, that's a little bit more predictable, but it's very subjective to your plan.

It's very subjective to your approach to life. Most people will be earning much more during the working lifetime than in the retirement years. That's what the data that I've reviewed indicates to me. That's why you'll find many financial advisors will usually recommend that it's better for you to do a deductible upfront option, because it's tough to accumulate enough money where your retirement income is going to be so high that you are going to be in a higher bracket in retirement.

It's tough. Is it possible? I don't know. I've tried to run some scenarios. I've never been satisfied with them enough to publish them. But of course, it's possible if you have excellent investments and you just become wealthier and wealthier every year. But if you just consider the mainstream median scenario, middle-class, median income earners who are working, if you think about it, many times a family is working hardest in their young years, lots of expenses involving kids, lots of expenses involving large mortgages.

Most people are at the highest earnings in those early years. Most people don't earn more in retirement than they do in working. So most people, their personal tax rates are going to go down. But is that specific for you? I don't know. You have to check that one out.

I just make you aware that that's going to be the biggest factor. And there's no perfect answer in the aggregate. It's all subjective. And at some point in time, you're going to have to make a guess. What about those other factors? As far as I'm concerned, those other factors are compelling.

And what I think is most reasonable is to make an assessment on an ongoing basis of which type of account you should use. It shouldn't be a standard decision of you always do this. It should be looking at my situation, my effective tax rate currently, my prognosis for income changes in the coming years, the usefulness of these assets, where do I want the money, do I want to have control of the money, etc.

That's where all the other shows we do and will do in the future, which dig into these questions, is very, very important. But today, I just want to leave you with that very simple math regarding the impact of tax brackets. For some of you, that may seem old hat, but I guarantee for some of you, that's the first time you ever had that math done.

I know it because that happened to me. A lot of you like to catch out your financial advisors. That's a fun one to do. I'll bet you some percentage. I wouldn't say a majority, but I'll bet you some percentage of you, if you want to have a little fun with your financial advisor, you might be able to catch them out in a moment of weakness and see if they've ever sat down and done that.

You would have been able to catch me out in the past. So I recommend that to you. This show came about as a response from an interesting email from a listener of a scenario that I'd never thought of for early retirement. I'm just going to leave it there with a teaser, but I've just spent the last hour and a half working on some interesting math of using traditional IRAs and 401ks for early retirement planning, taking income off of it, even when incurring the penalty.

It's got some interesting results. So I'm still fact-checking it and working on it, but I'll share that with you in the future. I might have that listener on who brought me the idea. It was brand new to me. I just say that in closing to say, if any of you guys ever have these ideas, I'd love to hear from you.

One of the greatest things, the benefits that I get doing this show is I get the benefit of interacting with you guys. I get the benefit of hearing from the collective intelligence. Many of you are so much more knowledgeable than I am. If you ever catch me in mistakes or you just have great ideas and you wonder if I've heard about them, please send them to me.

You can always do that, joshua@radicalpersonalfinance.com or just use the contact form on the website, which is now working. I love hearing from you guys. Thank you so much. If you would like to support the show and support the work that I do financially, please consider becoming a patron of the show.

I'm about to hit publish on this and I'm getting ready to do a Q&A call. Then later this afternoon, I'm going to spend some time in our Facebook group, answering all of the individual listener questions that have been posted there. Those are two of the biggest benefits of becoming a patron of Radical Personal Finance.

Biggest benefit is you get to know that you're supporting me. Thank you for that. Also, if you would like to have access to our weekly Q&A calls, to ask me questions specifically, to catch me out on anything, or if you'd like to have my answers and some of the answers of the other very smart people in our Facebook group, please go to radicalpersonalfinance.com/patron.

See your options there and become a patron of the show. Radicalpersonalfinance.com/patron. Hey parents, join the LA Kings on Saturday, November 25th for an unforgettable Kids' Day, presented by Pear Deck. Family fun, giveaways, and exciting Kings hockey awaits. Get your tickets now at lakings.com/promotions and create lasting memories with your little ones.

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