Hello everybody, it's Sam from Financial Samurai and in this episode I want to talk about the Roth IRA. So I was actually talking to my editor at Penguin Random House about the Roth IRA and the traditional IRA chapter and it made me realize how I missed the boat on contributing to a Roth IRA and it just reminded me of how I was so myopic in my thinking because when I first started Financial Samurai it was back in 2009 and I was making a good income and because I was making a good income I couldn't contribute to a Roth IRA.

For 2021 as a single person you must make under $140,000 to contribute to a Roth IRA and if you're married and filed jointly your modified adjusted gross income must be under $208,000 to contribute to a Roth IRA. So fortunately or unfortunately I wasn't able to contribute to a Roth IRA because my income back then was higher than the limits and the limits back then were lower.

So I thought to myself well screw the Roth IRA. I found it to be discriminatory. Why was there this arbitrary income figure that enabled people to contribute whereas some people could not? And I even wrote a post called the disadvantages of the Roth IRA which I'll link to in the show notes and it just goes through point after point on why you shouldn't contribute to a Roth IRA.

But again I had a very myopic way of thinking about it because I couldn't contribute. So if I couldn't contribute well why are other people contributing? But over time over time I recognized the fallacy in my ways. I also read through 600 plus comments arguing for and against contributing to a Roth IRA and I've come around.

I really have. And if you look through the progress over the years I wrote a post called why I never contributed to a Roth IRA but why you probably should. And as a father of two children now I think opening up a custodial Roth IRA is a no brainer.

It is such a no brainer. I'm recording this podcast to tell you that it is a no brainer. In the most simple example think about it this way. If you are a student you can earn twelve thousand five hundred fifty dollars tax free. Then you can contribute that tax free money up to six thousand dollars in your Roth IRA and then it can compound over the years over the decades without a tax drag.

And then when you withdraw that money it's tax free. So to not contribute to a Roth IRA when you're earning income below the standard deduction amount is foolish. And if you are earning a salary that doesn't face a high tax rate you should probably contribute to a Roth IRA.

For most of us as we gain more experience and expertise we're going to make more money. So that's really logical and therefore we're going to face a higher tax rate. So contribute to a Roth IRA when you're young when you're inexperienced when you don't make much money. Let's go through what the current marginal tax rates are the federal marginal tax rates.

So 10 percent up to nine thousand nine hundred fifty dollars. Twelve percent from nine thousand nine hundred fifty one to forty thousand five hundred twenty five. Twenty two percent from forty thousand five hundred twenty six to eighty six thousand three hundred seventy five. Twenty four percent from eighty six thousand three hundred seventy six to one hundred sixty four thousand nine hundred twenty five.

And after that it's the 32 percent bracket 35 percent and 37 percent tax bracket. So where is the biggest jump. The biggest jump is from 12 percent to 22 percent marginal income tax rate. So when you start making above forty thousand five hundred twenty five up to eighty six thousand three hundred seventy five.

That is the biggest jump. The second biggest jump is from 24 percent to 32 percent. That's an 8 percent jump. So once you start making over one hundred sixty five thousand basically up to two hundred nine thousand four hundred twenty five. You're at 32 percent. So the question you have to ask yourself is how much of a tax rate you're comfortable paying up front to the inefficient government so you can earn money tax free.

And what do you think your tax rate will be in retirement. Well here is some shocking news that I think some people don't believe. And that is you're probably going to make less money in retirement than while you are working. So if you think about that logic that in retirement your income and your marginal tax rate should be lower than while you were working at least during your middle and high income earning years.

That's really logical but a lot of people don't see it that way. A lot of people believe that they will be making even more in retirement than while working. Now they've got that mixed up. I think what they think they mean is they will have more net worth in retirement than while they were working.

That's logical. But from the income standpoint it's illogical. Therefore you need to think about tax differentials while you're working and while you're retired. And because interest rates have come down basically for the past 40 years it's going to take a lot more capital to generate more risk adjusted income.

It just simply does. It takes double the amount of capital to generate the same amount of income from going from 4% to 2%. So now that you have this logical framework in mind let's just go back to the federal marginal income tax rates. I don't think anybody should spend or pay more than 24% in federal marginal income tax.

Therefore once you make over $165,000 I don't know folks I don't think contributing to a Roth IRA is a good idea. Are you really going to feel good paying a 32% marginal income tax rate for your $6,000 contribution to your Roth IRA? I wouldn't because 32% is just federal.

If you have state it could be another 4% to 7% and that just doesn't feel good to me. Okay so forget about feeling good and feeling bad. Let's just run the numbers. At 32% the marginal tax rate you got to make over about $165,000 up to $209,000. How much capital is required to generate that type of income in retirement?

Let's just use $200,000 and divide it by 4%. You need $5 million in capital to generate $200,000. But how many Americans have $5 million in capital in retirement? The answer is less than 5% because the top 1% threshold is about $10 million. Now let's take a more conservative divisor since interest rates have come down and divide $200,000 by 2%.

Well now you need $10 million in capital to generate $200,000 a year in retirement. So the reality is I think some people just are not doing the math. You got to do the math and be realistic with your future net worth assumptions and income assumptions. Of course we're going to have social security.

The average social security amount is about $15,000 to $16,000 a year. And then you would add your investment income in retirement to come up with your estimated retirement income and marginal tax rate. And you know what's funny folks? This exercise on contributing above $165,000 is mute because the government saves us a little bit.

It saves us by saying only people who make less than $140,000 a year can contribute to the Roth IRA. So only people in the 24% marginal tax bracket can contribute. So when you think about it that way, then it's all about looking at the remaining tax rates of 10%, 12%, 22%, and 24%.

So I would take it a step further and say, well, once you start making $86,376 a year or more, that puts you in the 24% tax rate, I don't know if I'd be contributing to a Roth IRA. I would just contribute to a Roth IRA if I'm in the 22% or lower marginal income tax rate.

A 22% marginal income tax rate seems quite reasonable. All in, you're going to have an effective tax rate of probably in the teens with your federal income tax. So that's reasonable. You're keeping four times the amount of money than the government is taking from you. It seems pretty fair.

Therefore, max out your Roth IRA if you can at those income levels to diversify your retirement income streams. So one thing my father who's in his 70s told me was that I wish I contributed more to a Roth IRA because he's got social security, he's got a pension, and he's got to pay taxes on those required minimum distributions after age 70, and he's over age 70.

If he had invested in a Roth IRA, even if it's just $6,000 a year contribution for 10, 20 years, I'm not quite sure exactly what his income was, it would be a really nice sum of money that he doesn't have to pay tax on. So it is about diversification of your retirement income sources.

Now obviously, the next part of the equation is the future of marginal income tax rates. What will they be when we are retired? The fact of the matter is nobody knows, but we can look at the trend. The trend is down. Marginal income tax rates in America have come down from the 70s, 80s, 90s, and it's been great.

It's been a boon for capitalists. And given it's been a boom, and given we are all more accustomed to lower marginal income tax rates, it's really hard to see marginal income tax rates go up a lot for at least the middle class. Sure, the top marginal income tax rate is trying to be increased to 39.7% under President Biden.

Will it happen? I'm not sure, but even if it does happen, well, less than 5% of the American population will be affected, so it doesn't really matter. And then if we're talking about the Roth IRA perspective, it's a middle class retirement savings vehicle that has an income limit of $140,000 this year, so it really doesn't matter.

In conclusion, I say contribute to your Roth IRA to the maximum if you can, so long as your income is in the 22% marginal federal income tax bracket or lower. Now in the future, income tax rates might change, and whatever changes that may happen, I say continue to contribute to your Roth IRA so long as your marginal income tax bracket is about 25% lower.

Over 25%, I think it's a gray area, and it's kind of a wash. Your goal is to contribute as much to your retirement accounts as possible in a tax advantageous manner. The Roth IRA is one, the traditional IRA is another, but for pre-tax dollars, I would try to focus on maxing out your 401(k) every single year.

Do it, make it automatic, and your spending and your budget will adjust accordingly. I also want you guys to think about the Roth IRA and the 401(k) as kind of funny money. It's kind of like Social Security. If it's there for you after the age of 60, then great, but try not to count on it to live your ideal retirement lifestyle.

You've got Social Security, but more importantly, over the 40 years that you're going to be working after high school, you're building your taxable portfolio. Your taxable portfolio is your brokerage accounts. It can also be your rental property portfolio and other investments, as well as your side hustle and your business.

These are the investments and assets that are going to generate passive income so you can reach financial freedom sooner than the traditional 60 plus retirement age. And if you're happy working until 60 plus, then great, you found that job that provides you meaning, that provides you some purpose, and that's wonderful.

However, it's always good to think about your retirement income as a diverse portfolio due to tax liability. Taxes are our largest ongoing liability. There's no way around it, but we can be smart about things and we can diversify. So if you have any thoughts about the Roth IRA, I'd love to hear it.

I've definitely changed my tune over the years, especially now that I'm a father. And that's one of the most important things in personal finance, being flexible in thought, being open to new ideas and new perspectives, and to just try to keep an open mind when you hear something that might not sound quite right.

But the reality is it could be right for that person. So thanks so much and if you enjoyed this episode, I'd love a positive review. Take care folks.