Which Is Better - Traditional or Roth? (#54)

In this episode, host Josh Nelson dives into the pros and cons of contributing to a traditional 401K versus a Roth IRA. He explores the tax questions most people have about both.  Which is better? This episode goes into it giving you some great points that may help you decide what's right for you.

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Wiser Financial Advisor –  Which is Better, Traditional or Roth IRA?

Hi, Everyone. Welcome to the Wiser Financial Advisor with Josh Nelson, where we get real, we get honest, and we get clear about the financial world and your money.        

This is Josh Nelson, Certified Financial Planner and founder and CEO of Keystone Financial Services. We love feedback and we'd love it if you would pass it on to me directly: josh@keystonefinancial.com . Also please stay plugged in with us, get updates on episodes and help us promote the podcast. You can subscribe to us at Apple Podcasts, Spotify or your favorite podcast service. 

Let the financial fun begin!

Today we're going to talk about which form of Individual Retirement Account (IRA) is better. It’s Roth versus Traditional, and I can tell you that in 22 years of being a Financial Advisor, that's one of the most frequent questions I get asked. I’m not alone either—a lot of my colleagues also get asked: Which is better? Should I contribute to a Roth or Traditional IRA?

 What we're talking about here is retirement contributions. Those are the two basic types you can make, either the Traditional IRA or Roth IRA —which is often a Traditional 401K or a Roth 401K and their cousins.

Today we're going to get into some things to think about because this would be hours and hours’ worth of material if we really covered every single nuance with regard to Roth versus Traditional IRAs. So, I am going to tell you some of the things that pop into my mind as far as making decisions on this. There are some key things that you need to think about and that I need to think about because I'm doing this as well, right? I'm also contributing to a retirement plan 401K that we have here at Keystone.

Benjamin Franklin said, “In this world nothing is certain except death and taxes.” And that certainly applies here because the bottom line is that you do have to pay the taxes at some point on your income. With regard to choosing which should I do, Roth versus Traditional IRA, it really all comes down to this: When do you want to pay your income taxes? 

And you might say, “How about never, Josh?” Unfortunately, that's just not an option. As Ben Franklin observed, you do have taxes. It's going to happen on one end or the other because income does get taxed in this country. So before we really answer which IRA is better, let's go over how these plans actually work.

A Traditional 401K is the pretax variety. That's where you're diverting dollars of your income into a pretax investment so you don’t pay taxes on the income for the year that the income comes in. We're going to cover 401K contributions because I do find that's where people are mostly contributing right now through their work retirement plan. And most employers, bigger employers at least, do offer both Roth and Traditional choices. Here at Keystone we offer that to all our employees. They can either choose Roth or Traditional. 

So, the Traditional 401K allows us to divert dollars pretax. What pretax means is that there's a tax benefit right now, this year. Depending on what tax bracket you're in, it might only feel like 80 to 60 cents on the dollar that you’re putting away. In other words, if you put a dollar away in a Traditional IRA, it might not actually feel like a whole dollar. There is some advantage there from a cash flow standpoint because the income doesn't hurt you in taxes right now. And if you're really diligent, you could bump up your contributions faster and put a larger percentage into that IRA than if you were feeling that full dollar. 

So with the Traditional 401K, these are our pretax dollars. Keep in mind employer contributions. Your employer contributions always go to the Traditional or pretax 401K. That's just the way it works. There's no choice from the employer; they're not being mean. It is required to go that way because it's an employer contribution. And yes, they get a tax write-off when it goes in, but nonetheless it does have to go to the pretax variety of the 401K.

One other thing to keep in mind with retirement contributions to a Traditional 401K is that someday when these dollars come out, you want to pay attention to the age you are when you withdraw any funds. If you withdraw funds before age 59 and a half, that’s called early withdrawal and there is a penalty of 10% applied to that. Once you're age 59 and a half or older, you're no longer penalized anymore, but those funds are still taxable when you take those dollars out. They are taxable as ordinary income in the year when you take the money out. Therefore, these tax consequences can have a big impact later on, even though it might feel good to get the tax benefit today.

One other nuance with Traditional 401K's or Traditional IRAs both is that required minimum distributions are applied to these plans. When you hit age 72, (it used to be aged 70 and a half, by the way but now it's age 72) you are required to calculate and withdraw a required minimum distribution. And when you withdraw those required minimum distributions from your retirement plan, they are taxable at that point. Assuming that you live beyond age 72, eventually the IRS is going to force you to start drawing dollars out and those dollars will be taxable as ordinary income.

Now, let's go over Roth 401K. These are after-tax contributions. Again, this is Traditional versus Roth 401Ks. With after-tax contributions, you don't get any tax benefit up front and so really what you're doing is pre-paying your taxes. You're paying the full taxes on that dollar we talked about before. It feels like the whole dollar is being taken out of your paycheck, meaning that you're paying the tax dollars now on that income. the When you contribute to a Traditional 401K you're thinking, “Well, that's a pretty good deal to avoid taxes this year on that income that’s going into the Traditional 401K.” That’s especially true if you are getting into higher income tax brackets and trying to figure out, “How can I get some deductions here?”

A couple years ago they simplified the tax code a bit by raising the standard deduction quite high, so most people don't end up itemizing their taxes anymore. For a lot of folks, there just aren't a lot of deductions to be had, other than contributing to a Traditional 401K if your employer allows it. If you're self-employed, you can also do this. Keep that in mind. You can set up your own Traditional 401K. If you want to do this, let us know and we can talk to you about it. 

So, back to a Roth 401 K, we're feeling the full impact of the dollars we're putting in right now, but you believe that you're better off forgoing the tax benefit now because you really like the idea that all the growth coming out of that investment in a Roth 401K will be tax-free later on. You get the benefits along the way. All the earnings, all the growth that ends up happening with those dollars will be tax-free later on, and they're tax-deferred as long as you're not drawing money out early. The same age applies; age 59 and a half is the magic age you need to get beyond.

There are a few exceptions to that, but just for simplicity’s sake today, you have to get beyond that age before you will be able to draw dollars out without being penalized or taxed. So again, in the case of the Roth 401K you get tax-free distributions later on. 

If you have an employer plan that's doing matching, just to make it clear here, even if you divert 100% of your contribution money into the Roth 401K option, their money is still going into Traditional, so someday when you leave that employer, more than likely you're going to roll that out. You probably don't want to leave that with an old employer, so you'll roll that out, and the pretax portion goes to a Traditional IRA and the after-tax portion would go to a Roth IRA, so your rollover would be split depending on what way you picked to divert your money. You could end up with some Roth dollars, or you could end up with a lot of Traditional dollars.

By the way, these are great problems to have, right? Making these choices means that you've probably reached some level of financial stability. We always talk about some basics and I hammer on these a lot because they're so important. 

Number one, we want to make sure we've got emergency funds available in case something bad happens. And as Murphy says, something bad will happen. We know that's just part of life. If we're working, if we've got a house, if we've got a car, if we've got a family, there's going to be stuff that happens. Unexpected expenses will come up. That's why we want three to six months’ worth of living expenses in an emergency fund set aside at all times. That’s money just sitting in the credit union or in the bank. It isn’t probably earning a whole lot of interest right now, but it’s there for that rainy day when something happens that was unexpected, a true emergency. Then you'll be able to draw from that fund. 

The other thing we want to make sure of is that you've got all your consumer debt paid off. Get that stuff paid off as fast as possible. A mortgage is okay. It's one of those things, because most people can't just write a check and buy a house. If you can, good for you, that's awesome, but in most cases people can't just write a check. And the other thing that's nice about real estate is that it has the ability to appreciate, and it tends to do so with inflation over time. So when we're paying that mortgage down over time, we're probably also receiving some appreciation in the value of that property. Just about everything else we buy only goes down in value—cars and boats and whatever else we're putting money into go down rather than up. It's fun and it's nice to be able to buy those things, but they're not going to go up in value. They’ll go down to zero eventually. So keep in mind that we want to have paid off all consumer debt.

Now, we're talking about retirement savings because we've reached that level of stability that we're talking about the future. We’re talking about the percentage of income that we want to be putting away. Ideally our retirement money—not including the employer match—is going to be a minimum of 15% of our income. Your retirement income is probably going to come out of these funds later on. So, 15% of your own money going away if you get some matching, that's great. Even more ideal would be 20%, putting 20% away for the future plus company matching. If that's the case, that's great. 

You might ask why I’m not including company matching in the percentage that I’d like to see you put away. It's because of two things. First, that match is not guaranteed. And many of you who have worked at different companies know that when we hit recessions, or even if a sector of the economy or a company is having struggles, they're going to be finding every way they can to save money during that time period. One of the things they will probably do is look at the company match and either how to cut that or suspend it temporarily to save money. It’s not a guarantee that they're putting money away for you. Second, there are vesting periods on the matching with almost every company, meaning you've got to be there a certain number of years before you get 100% of that match money. So to be safe, it’s always better to figure out your own money and how much you're diverting away. Then if you get matching, that's great, you'll just grow faster.

Now, in choosing whether to do Traditional or Roth—the nice thing about the Roth 401K or Roth IRA option is that there are no required minimum distributions on those! One asterisk to put on this is that what we're talking about today is how things work today under the current rules. We could rabbit trail and talk about all the things that Congress could do this year or next year. They could end up changing the rules over time. We can kind of guess what might happen. I think there's a pretty good chance that tax rates are going up in general over time, but in the end we really don't know what's going to happen in the future, so we really want to just plan with what we know today. These are the rules today.

Now, back to the question of which is better Roth or Traditional, my favorite answer as a Financial Planner is, “It depends.” When do you think taxes are going to be higher for you personally—now or later? That's a key question you really have to answer with regard to which plan you put money into, Roth or Traditional. When do you personally think that taxes will be higher for you and your family—now or later? 

Historically, we're at pretty low tax rates right now, so some people are thinking about that and saying maybe we should just rip the band-aid off. Maybe we should just pay the taxes now because we know what they are. 

We like the idea of tax-free later on, so, I like to say it depends but if I'm pressed for my personal opinion, I do like Roth in general. I like Roth simply because we know what tax rates are today. We like the idea of tax-free growth. We like the idea of not having any required minimum distributions in the future. And the nice thing about Roth is that it gets passed on tax-free as well. At least that's how it works right now. All of what you put in along with everything that has accumulated in interest or other gains will pass tax-free to whomever your beneficiary is for that account.

That's a pretty good deal, I think. It's better to rip the band aid off now and do whatever you can stomach to get into a Roth right now. I'll tell you that from a contribution standpoint, it makes sense. These are your dollars. (Again, company dollars go to the Traditional.) So, thinking about your dollars going into a Roth IRA or Roth 401K makes a lot of sense. We'll talk about conversions here in a little bit, but there are opportunities for those of you who are listening and say, “I'm not working anymore.” Or maybe, “I'm in a position where I don't have a company plan available to me, so I can't do that.” In that case, maybe there are some options with Traditional IRAs and Roth IRAs that we can use to plan around.

In general, I like Roth, ripping the band aid off. Bite the bullet and pay the taxes now. The income taxes we're paying right now are historically pretty low. They're likely to go up with the trillions of dollars of debt and unfunded programs like Social Security and Medicare. I’m not being critical of these things, not getting into politics at all, but the bottom line is that there's a lot of stuff to pay for, and we've got to have some revenue to do that. You can't just borrow money indefinitely. At some point you do have to pay your bill. And we haven't been doing a very good job of that recently, so we are probably going to have to look at some higher tax rates in the future to be covering these things. Either that or cut stuff someplace else in the budget. The country’s budget works the same way as our personal budgets, and right now the amount of money that's being borrowed means we're going to have to make some big changes at some point in the future. Probably sooner rather than later.

So, when do you think tax rates are going to be higher for you, now or later? Do you think that you're going to spend all your retirement money, or do you think that passing it on to somebody else is probably in your future? These are things you've got to decide on what you believe and then we can go forward. 

Would you want to pay taxes on the money now or later? And again, I know you don't want to ever pay it, but in some cases people like the idea of prepaying their taxes and getting that out of the way. If you like that idea and you’ve got the money, you've got the cash flow, you might as well say, “Let's just pay the taxes now. We like the tax-free later.”

Another thing to think about is that it doesn't have to be all one or the other. You have a choice when you sign up for your 401K. assuming they give you both options. Just to be clear, some employers out there have not enabled the Roth option. If they haven't, I would ask your benefits people if they can add it, because generally speaking it doesn't cost them more. It's just a tax thing in the background, so it won’t cost your employer more to open up that option and allow for Roth contributions from you. It gives people choices as far as when you're going to pay the taxes.

Another point to talk about is something called tax diversification. When it comes to retirement contributions, we want to consider tax diversification. Because I work with people across the whole spectrum from people just starting out all the way up into their retirement years and I’ve been doing this a long time, I've seen a lot of things that have worked out well and some things that haven't worked out so well. One thing I can tell you is that we would never put all our eggs in one basket from an investment standpoint. So, why would we do that with our taxes? Why have everything in one bucket? 

Let me give you an example. Sometimes people are very, very good savers. People we’ve worked with as clients are great at putting money away. They live below their means. When it comes to accumulation, sometimes people do such a good job adding money into things like a Traditional 401K for example, that they have a nice big bucket of tax-deferred money at retirement. Which sounds great, but it might be that almost 100% of their investment portfolio is in tax-deferred accounts. Sounds good because we're conditioned that we don't want to pay taxes. We're trying to reduce taxes. We're trying to accumulate a lot of wealth and do it in the most tax efficient way. But if we're thinking about today only, that means we're going to put it all into pretax things and we might end up with a big bucket of tax-deferred money later on. That doesn't give us a lot of tax flexibility from a planning standpoint. 

Think about the number of years you're likely to spend in retirement in the U.S.; late 70s is the life expectancy right now. And that's going up as a trend, I think. It dropped a little bit over the pandemic, but in general those numbers have been going up, and with the medical advances we’ve seen, it's pretty likely when you retire that you might have several decades. You could even have 4 decades in retirement, depending on when you're done working. Think about that. That's a lot of years. That's a lot of presidents. That's a lot of congresses. That's a lot of tax change along the way. 

So, going back to those questions: When do we think our taxes are going to be better—now or later? When are they going to be higher, now or later? We don't know. That's the honest answer. We don't know and the reality is, it's going to be all of the above over a 30 to 40 year retirement. Think about the number of presidents and congresses. Think about how many changes have happened over the last 30 to 40 years. There have been high taxes, low taxes, high inflation, low inflation. There have been terrible recessions and awesome expansions. So, think about everything you’ll be going through. It will be something similar. The details won't be all the same, but it's at least going to rhyme. There will be volatility and there will be planning opportunities for people who have tax diversification. It’ s nice to have different buckets of money, not just from an investment standpoint, but from a tax standpoint.

Let's unpack that for a minute. When people ask me, “How much should I have in one versus the other?” Well, ideally it's good to have both, and in fact it would be nice to have half in each as far as retirement funds. I think it's also good to have some other buckets of money that aren't retirement funds. It’s good to have our cash bucket we talked about—that three to six months’ worth of living expenses. I would go higher on that in some cases, depending on your situation. If you have some major expense coming up that you already know about, of course that should be in cash in addition to that three to six months’ worth of living expenses. If you have a lot of uncertainty in your life right now, like you're worried about your job or your business or something else is kind of crazy at the moment, maybe go higher than three to six months. Your particular situation matters, and everybody's situation is different. You all have your own values. I've got my own values. We're all going to have that as an overlay with these decisions we make. 

I think tax diversification is a good thing. When I sit down with a client today we’ll look at where their money in retirement will be coming from. Maybe Social Security or maybe they're one of the few people who get some kind of a pension from a company or the government. In most cases it's Social Security plus the withdrawals people are taking from their investments. If we have different buckets of money, that means we've got the ability to pull from different places depending on the situation that year. Again, the tax code can change. You might have had an extra expense where you needed to take money out to buy a new vehicle. There could be various circumstances. It would be nice if we had those different buckets from a tax standpoint. 

For example, what if we had a Traditional bucket that was pretax, which means it will be taxed when we draw from it? But what if we had another bucket that was Roth money, which is after-tax and therefore tax-free when taking the money out? And what if we had a third bucket of just taxable investments, a brokerage account that includes things that have already been taxed. In other words, it was funded with things that were after-tax, but it might be money that doesn't have to abide by any special rules like we've been talking about with this other stuff. It's nice to have all three, ideally. In addition to that emergency fund, have a taxable investment bucket, a normal brokerage account. 

A non-retirement account doesn't mean you won't use it for retirement. It just means it's after-tax money that doesn't have to play by any special rules.  I've worked with a lot of people over the years and sometimes people end up retiring early, which at least from an IRS standpoint would be before age 59 and a half. So Traditional or Roth money has got to stay until 59 and a half or it gets penalized if it’s withdrawn sooner. People that have been very good savers and investors over the years may have accumulated enough money to be able to retire. There have been a number of times that I've run across folks who did such a good job putting money into those buckets that they got to retire early. But then we're looking at things and it gets tricky as far as, “How do we pay the bills if we don't have access to those accounts without penalty?”

Again, there are some exceptions, some strategies we can use to get at that money a little early, but it's nice to have that third bucket of investments, that brokerage account holding some investments that are building up in addition to the Roth and Traditional IRA money.

I know that's a lot we've talked about today. We could go hours on this topic because there are many nuances, so of course you will want to consult with your own Financial Planner. Hopefully that's us, but whoever it is, you're going to want to meet with your own Certified Financial Planner and probably your tax advisor as well. If you've got a tax advisor, getting them in the loop on this would be a good thing, but certainly being thoughtful about this and being diligent about the whole process rather than leaving it to chance is really important.  We're going to be looking ahead and looking at things as objectively as we can today as far as how we have things set up now, what our resources are and what our future might look like.

The financial planning process is detailed enough that it's going to dig into things and help you feel confident about your decisions. It's not going to be just winging it, which is what most people are doing. Frankly, most people out there are just kind of winging it financially and they just hope they're going to be okay at retirement instead of actually having a plan that's being executed.

Making plans doesn’t mean they're guaranteed. Mike Tyson famously said, “Everybody got a plan until they get punched in the mouth.” And that's true. With a lot of the things in life, we come up with our plans or things we think are going to happen, things we want to do. Then reality happens. Things happen to us health-wise and financially. There are job changes and good and bad windfalls. All kinds of things end up being a great opportunity to be able to really look at things in advance so we're not just reacting. We want to be proactive and come up with a plan using time-tested principles from a financial planning standpoint, using somebody like myself or someone else who's experienced, someone who has seen a lot. They know what works and what doesn't. It’s important because this is your future and this is my future.

We have tools. Tax tools and financial planning tools. We can do projections. We can do estimates on taxes and so forth. We can help you decide. We can certainly support you on that. Our clients get that as part of the comprehensive financial planning service they receive. And as far as becoming one of our clients, if you're wondering if you qualify and whether it makes sense for you to become a client, let's have a conversation. Not that we know everything in the world, but we are trained and have a lot of experience in areas that are going to be surrounding retirement planning, taxes, employee benefits, all kinds of stuff that relates to your life and your money.

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So thank you so much. We here at the Wiser Financial Advisor want to be the antidote to fear and pessimism out there in the financial world. We know there's too much information and we know that a lot of it is conflicting. It's very confusing out there for a lot of folks, and many people just do nothing because they don't know what to do. Our job as Financial Planners is to support you. We're always here for you. Please let us know if there are any topics you'd like us to cover.

Have a great week and God bless.

This episode has been prepared for informational purposes only and is not intended to provide and should not be relied upon for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors. Investment advisory services offered through Keystone Financial Services, an SEC registered investment advisor.