Should I contribute to a Roth IRA or Traditional IRA?
Transcript:
0:00 What's going on everybody? Thank you for stopping by. My name is Phil with Foundation Wealth Planning. I am also a CERTIFIED FINANCIAL PLANNER™ and I get this question all the time.
0:12 Should I contribute to a Roth IRA? Or a traditional IRA? And this question also would apply to a Roth 401K versus a traditional 401K.
0:19 The same concept would be valid, but we're going to use the numbers for an IRA just to simplify things. But I want to go through this.
0:27 This is going to be for educational purposes only. This is going to be not financial advice and not tax advice for you.
0:33 This is just running some examples that I hope give you a little bit of insight on a thought about this that is not talked about.
0:44 So here's what we're looking at. Well, before I run the numbers, let's just do a real basic run through about a traditional IRA versus a Roth IRA.
0:54 So a traditional IRA is the OG been around longer. When you put money into that account. Anytime you put money in, you're going to be able to deduct that off of your taxes, right?
1:05 The money's going to grow tax deferred. And then when you get into retirement and you take the money out, that'll be taxable at that point in time.
1:13 And the Roth is going to be the opposite of that, meaning you put the money in, and there's no tax help on the front end, which is sad.
1:21 Right? We like getting tax help, you don't pay as much in taxes any year. But then that money is going to grow tax free because when you take the money out in the future, it is not going to be taxable.
1:33 And that's real nice. Okay. So when we look at the Roth vs traditional, you know, a common point that people will say is saying, Hey, I'm in a higher tax bracket now.
1:45 And I'm going to be in a lower tax in the future. Why not just do the traditional, take the deduction now and then pay the taxes in retirement when I'm in a low tax bracket.
1:57 And that has some validity to it. I mean, that's certainly a fine way to think about it. But there's a bit of a nuance there that I think most people are overlooking.
2:05 So let's, let's look at this. If we just run a few numbers out on this and say you've got a $6500 contribution limit per year.
2:12 That's the same number whether it's a traditional IRA. Right. So we put the $6500 in, let's do it over 35 years, 7% rate of return.
2:21 We're going to start from zero and we contribute that dollar amount at the beginning of every year. Well, in the future, then you would have based on the.
2:28 These numbers, are $961,437. So if we took that amount, that is actually going to be the same, whether it's a traditional IRA.
2:41 Or a Roth IRA. You might say, well, Phil, I thought there was some sort of tax thing that might make one there than the other.
2:48 Aha, you're right. But in the account itself, it's the same if you're maxing it out on both accounts. So the difference is when you get that tax deduction for the traditional IRA, you need to be investing that in order to make that better.
3:05 Because in this point, for instance, if you spend it, if you just spent your tax deduction, where you're going to the same amount of money, this amount in the Roth is going to be tax free.
3:15 But the traditional IRA, this money is going to be taxable. This a dollar amount right here. So you might. Say, well, why wouldn't I just do the Roth?
3:24 Well, fair point. If you aren't going to invest your tax savings on the traditional IRA, then it probably would be better off just to do the Roth.
3:32 So let me show you what I'm talking about. If we look at this tax savings that you could potentially have, let's use a 32% tax bracket, which is a high tax bracket, right?
3:43 Most people are not going to be in that tax bracket. And so your numbers are going to look even different than this, but let's just say $6500 contribution times a 32% tax bracket would be a potential savings of $2,080 in taxes for the year.
3:58 Okay. Most people are going to just spend that. But if you're going to just spend it, you should have just done the Roth, right?
4:05 The only way the traditional IRA could be better Roth for you is if you invest that dollar amount. Right? So if you took that $2,080, and you contribute that annually, now this has to go into a taxable account because you don't have any room left in your IRA.
4:22 Over 35 years, and you've got a 7% rate of return, the net's actually going to end up being a little bit less because you have to figure taxes with it being taxable investment account.
4:33 We'll just use 7% just for simplicity. We're starting at zero, contribute at the beginning of the year. Well that would give you an extra $307,660.
4:44 So if you, if that's, if you did a traditional IRA, you got a tax deduction and you saved and invested the deduction, well then you'd be able to add that to the
4:56 $960,000 and it's going to give you close to 1.3 million in total assets compared to the $960,000 in Roth.
5:03 And that because you have to take taxes when you withdraw the traditional, that's how it would kind of balance those out.
5:08 Now the next part of the calculation to really figure out what would be better for you would be to, you have to estimate future tax rates, figure out what you withdrawal would be and how much you paying taxes and that's much more complicated.
5:21 And we're not going to go into that point. This time, because then you also got to figure out what your future income is going to be and what the future tax rates are going to be.
5:28 It's a lot of assumptions. My simple point is, to sum it up. If you're going to do the traditional. IRA, you need to invest what you're saving in taxes.
5:41 Otherwise, you should just investigate doing a Roth, right? That might be a better option for you. So I hope that helps.
5:49 I hope that really drives home the point of it's, it's complicated, but simple. Roth IRA is easy. The traditional IRA might be better for you, but you gotta remember, don't forget to invest
6:02 your tax savings. So hope that helps again, please reach out. We'd love to help anybody that has questions on this.
6:09 And in the meantime, God bless. We'll talk to you soon.
Phil Francois CFP®
Foundation Wealth Planning
https://www.foundationwealthplanning.com/