Ready For Retirement
Ready For Retirement
Roth vs. Traditional IRA – Which One Really Saves You More?
Is a Roth IRA really better than a traditional IRA? The truth is... it depends on your tax situation. In this video, you’ll learn why your current tax bracket versus your retirement tax bracket should drive your decision, not blanket advice.
Most retirees pay less in taxes later in life, which creates opportunities for smart strategies like tax arbitrage and Roth conversions. By contributing to traditional accounts during high-earning years and converting in lower-tax years, you can potentially save thousands (even hundreds of thousands) over your lifetime.
James also covers why neither Roth nor traditional accounts are truly tax-free, and how tax diversification gives you flexibility to manage income in retirement. With a real case study, you’ll see how strategic Roth conversions added more than $100,000 to retirement assets.
Listen now to discover how to choose between Roth vs traditional IRAs and optimize your retirement tax planning.
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Advisory services are offered through Root Financial Partners, LLC, an SEC-registered investment adviser. This content is intended for informational and educational purposes only and should not be considered personalized investment, tax, or legal advice. Viewing this content does not create an advisory relationship. We do not provide tax preparation or legal services. Always consult an investment, tax or legal professional regarding your specific situation.
The strategies, case studies, and examples discussed may not be suitable for everyone. They are hypothetical and for illustrative and educational purposes only. They do not reflect actual client results and are not guarantees of future performance. All investments involve risk, including the potential loss of principal.
Comments reflect the views of individual users and do not necessarily represent the views of Root Financial. They are not verified, may not be accurate, and should not be considered testimonials or endorsements
Participation in the Retirement Planning Academy or Early Retirement Academy does not create an advisory relationship with Root Financial. These programs are educational in nature and are not a substitute for personalized financial advice. Advisory services are offered only under a written agreement with Root Financial.
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Everyone always tells you Roth accounts are better than traditional accounts. Pay taxes today, put money in, let it grow tax-free, and one day that money comes out to you tax-free in retirement. There's a beautiful thing about that, but Roth accounts are not always the best. There are many cases when the decision to put money into pre-tax accounts could save you tens or hundreds of thousands of dollars compared to putting it into Roth accounts. So, roth or traditional, what's best for you? That's exactly what we're gonna explore in today's video and even show you a case study to quantify the difference and show you how much this could possibly save you. Let's jump into three myths today that you commonly hear to show you what's actually true and how you can actually apply this to your specific situation. Myth number one is that Roth is always better than traditional. Here's the actual principle. You want to put money into pre-tax accounts if taxes today are higher than they'll be in the future. But what does that mean? Taxes today are higher. That's where people actually get tripped up. Taxes today being higher doesn't mean what are federal tax brackets today? What are state tax brackets today? That's one component of it, but what I'm actually concerned about is what is your specific tax bracket, which is a function of two things. One is general tax brackets as a whole, federal and state level. But more importantly, what will your actual taxable income be?
Speaker 0:So often in your working years, all of your income is subject to the same tax rates. It's ordinary income. It's wages. You're paying full federal and state taxes on all that income. But that changes dramatically for most people in retirement. In retirement, for the most part, you have less income coming in and you can still maintain the same lifestyle. It's maybe because you no longer have a mortgage, you're not supporting children, you have fewer expenses in general in your retirement years than you did in your work years, so you need less income to still maintain the same lifestyle. That's part one, but part two is the way income is taxed in retirement tends to be more beneficial.
Speaker 0:Here's just a couple brief examples of how Social security. Social security is a core income source for many people. It has favorable tax treatment compared to other types of income. No more than 85% of your social security benefit will be included in what you pay taxes on. On top of that, most states don't actually tax social security benefit will be included in what you pay taxes on. On top of that, most states don't actually tax social security at all, even if you're in a high income tax state, so check with your specific state there.
Speaker 0:On top of that, a lot of times in retirement people might be living on cash or brokerage accounts. With cash or brokerage accounts, that's money that you're pulling out, much of which you've already paid taxes on, and in the case of your brokerage account, any money that you're pulling from that isn't what you put in. Those gains. If they're long-term, capital gains are going to be taxed at lower rates than ordinary income otherwise would have been. Now, on top of this, as you turn 65 and older, you have an increased standard deduction. So all these factors combined to say, on average, your taxes in retirement for the same level of taxable income in your pre-retirement years is going to be lower. So don't just say I think taxes in the future are going to be higher.
Speaker 0:Therefore I'm going to do a Roth. Today. That could be the case, but really what we're concerned about is what will your tax bracket be in the future, based on your taxable income, and how that compares to overall tax brackets? So there's the myth that Roth is always better. Roth accounts are wonderful, but they're not always better. Make sure you understand your tax bracket today and your tax bracket in the future to make that decision. This ties into the second myth, that Roth accounts are tax-free and traditional accounts are not. Neither are tax-free.
Speaker 0:The decision comes down to when do you want to pay your taxes With a Roth account? If I put $5,000 into a Roth account today, I pay taxes on that full $5,000. What I don't pay taxes on is the growth and the future withdrawal from that account. With the traditional account, I'm not paying taxes on that $5,000 today. If I put that $5,000 into my traditional 401k or traditional IRA, it's saving me taxes today, but when I pull money out of that account in the future, I'm going to be paying taxes on that. Here's where people get tripped up, though, on that is they see that $5,000 example and they say that only costs you $1,000 in taxes. Think of how much you're going to save over the long term.
Speaker 0:Here's a better way to think about it. Assume that the only income you have this year is $5,000. You have the decision Roth account or traditional account. And for simple math, let's assume that you're going to be in a 20% tax bracket today and a 20% tax bracket in the future. Well, if you make the decision to go Roth with that, that $5,000 comes in, $1,000 of it is paid in taxes.
Speaker 0:$4,000 actually gets invested into your Roth IRA today. So $4,000, let's assume that continues growing tax-free as it will, but you pay $1,000 in taxes versus the IRA. If you put $5,000 into a traditional IRA, there is no taxes today, so a full $5,000 gets invested. So that's the true apples-apples comparison. Now let's assume a growth rate on that. Let's just assume, for simple math, your investment grows by 10 times from now until the time that you need to spend it. Well, with the Roth, that $4,000 turns to $40,000. That $40,000 is all completely tax-free to you. That's a wonderful thing, a wonderful account to have. With the traditional IRA it also grew by 10x, but you have $5,000 in that, so that $5,000 now grows, grows to 50,000.
Speaker 0:Well, if I take that full 50,000 out in the future, apply a 20% tax bracket, that means I'm paying 10,000 of it in taxes and I end up with $40,000 after tax, the exact same amount as I would have had with a Roth IRA. So sure, the taxes I paid were higher the 10,000 there versus the 1,000 with the Roth today. But we have to keep in mind there's no difference there. The only difference is when I'm deciding to pay those taxes. So, all else being equal, roth and traditional accounts are the same, but things are not always equal. There's always going to be a difference in taxes, whether it's federal taxes, state taxes, medicare taxes, anything like that. Those are the details, the nuances that should determine where your money.
Speaker 0:Now let's do one more myth before I actually show you a case study to show you how you can apply this to save tens or hundreds of thousands of dollars with your specific planning. But the third myth is that you should choose one or the other. Typically, people are all in on traditional or they're all in on Roth accounts. The reality is, having both gives you a tremendous amount of flexibility in your retirement years. And I'll take a step further not just traditional accounts and Roth accounts, but also brokerage accounts.
Speaker 0:When you go into retirement with a diversification, not just of the types of investments you own, but where you own them, it gives you a huge amount of flexibility to determine the right tax strategy, or to create the right tax strategy. Because what people don't realize is, in retirement, you get to manufacture whatever level of taxable income you want. It's not like your working years, where if you earn $100,000, that full $100,000 is taxed. Well, in retirement, if you have social security plus brokerage accounts, plus IRAs, plus Roth IRAs, plus maybe a few other random things, what you can do is you get to decide if I'm trying to create $100,000 of income, how do I want to create it, how much of that might come from social security? How much of that should I pull from my traditional IRA versus my Roth IRA versus my brokerage account? And with some good, serious planning, you can create the lowest possible tax bracket while still generating the level of income that you desire.
Speaker 0:Let's take a look at a case study to illustrate what I mean by this. We're looking at a sample client here. This sample client's name is John, and John has about $1.6 million in his investments and what you can see is he does have that diversification of assets. Most of his money is in his 401k, but he has some in a Roth, he has some in a brokerage account, some in I-bonds, cds, company stock, et cetera. And what John's trying to do is he's trying to come up with the right tax strategy to say both where should I put money today in terms of IRA versus Roth IRA, and then what should I be doing in retirement? And I'm going to show you a very simple breakdown of how he should be thinking about that.
Speaker 0:What we really want to know for John is what is his tax bracket today? Going back to what I said before, I'm not just concerned with where our federal tax bracket is today and where do I think they're going to be in the future, because number one, that's just a guessing game, but number two, that's not even the most relevant point. The most relevant point is where will John's specific taxable income put him on those federal tax brackets? And as we look at this right here, john is working and so he's in a 24% tax bracket today, but when John retires, he's projected to be in a much lower tax bracket. He's expected to be in a much lower tax bracket. He's expected to be in the 10% to 12% federal tax bracket for a fairly long time until required distributions kick in and those required distributions are projected to push him right back into the tax bracket he's at today and actually by the end of his life, he's expected to be in a higher tax bracket at that point than he is today, not because he's all of a sudden spending way more money, but because required distributions will push him his distribution amount above certain thresholds and force him to pay that in income.
Speaker 0:So what can John do? Well, the first thing he can do is he can look at this Now. This is already based upon a whole lot of planning and projections and assumptions, so we have a good map of where we expect John to be. But the first piece of feedback is let's prioritize pre-tax traditional accounts today. At a minimum, we can save 24 cents on the dollar for any contributions today, and when we pull that money out a couple of years later it might only cost us 10%. So, right off the bat, there's a 14% tax arbitrage opportunity right there. So that's the first thing.
Speaker 0:But the second thing is this Now, what we can start to look at is some more serious tax strategies. And for John, what we want to know is how do we not just say what is your expected tax bracket to be all the way throughout retirement? It's, what can we do to capitalize on that? And so, once again, what we're looking at here, what we're looking at in the purple, is this is John's taxable income before any type of tax planning simply a projection of what will your various income sources look like when we stack those on top of the 10%, 12%, 22% tax brackets. So we can start to get a sense for where might you be.
Speaker 0:But whenever I see this, this is that tax planning value, or that tax planning window of saying, john, you're in higher brackets today, you're expected to be in higher brackets in the future, in fact, much higher brackets in the distant future. What can we do? What opportunities can we take advantage of in these years right here to manufacture income or to pull some of that income from future years and even current years into that, so that we can fill up the 10% or fill up the 12% bracket and, in doing so, lower the tax brackets on the edges right here. How do we do that? Well, in these years more contributions to pre-tax accounts. That's lowering the overall tax liability today because we're in a 22 to 24% tax bracket. Same thing in the future.
Speaker 0:So this is what we would look at for John is, if we go through this and we simply say can we fill up the tax bracket, what does filling up a tax bracket mean? It means, when we look at his projected taxable income in these years. This green line is showing what's the threshold for where he would meet the 12% federal income tax bracket, meaning he's created enough income that he has filled up every dollar that could be taxed at a 12% federal tax bracket. We do that by converting just enough from pre-tax accounts to Roth accounts, so let's see what the impact of that is. So if we run this at the 12% bracket, I want to see what does that actually do for him.
Speaker 0:That decision alone leads to $100,000 plus of tax-adjusted ending assets. So don't just look at this as tax savings. As great I saved money. Look at this. What else can you do with $100,000 for your retirement? What would that mean in terms of other trips you could take, other things you could do with family or loved ones, other legacy amounts that you could leave behind when you're no longer here. That's the power of understanding whether you should do pre-tax accounts or Roth accounts today and then turning that into a tax strategy during your retirement years.
Speaker 0:Now, by the way, if you're looking at this and you want to be able to use this exact software for your needs, you can get access to it in the Retirement Planning Academy below, and that academy actually walk you through video courses, not videos that are already on YouTube, but video courses step-by-step. How would we think about retirement planning at our firm, root Financial, so that you can apply the same concepts, even use the same software, with your situation? So get access, go through this module, go through this planning scenario on your own if you want to. Access is in the Retirement Planning Academy. But when it's all said and done, the decision that you are making should I use a Roth account or a pre-tax account or a mix of both very much comes down to a few core things that, if you get these decisions right, it could be the difference of tens or hundreds of thousands of dollars over the course of your retirement.
