Roth IRAs often are touted as being superior to traditional IRAs because Roth withdrawals are tax-free in retirement. A closer examination, however, shows the Roth-vs.-traditional playing field is more level than it seems.
SMI executive editor Mark Biller explained why on Moody Radio's MoneyWise Live.
To listen, click the play button below — or, if you prefer, scroll down for a transcript. (For more radio appearances by members of the SMI team, visit our Resources page.)
MoneyWise Live, with hosts Rob West and Steve Moore, airs daily at 4:00 p.m. ET/3:00 CT.
To ask a question on a future program, call 1-800-525-7000 and mention you have a question for either Mark Biller or Matt Bell of Sound Mind Investing.
Steve Moore: It's the age old question, should I open a credential or a Roth IRA? Each has its advantages and our host, Rob West welcomes investing expert Mark Biller to help you decide which IRA is right for you. Then it's your calls and questions on anything at 800-525-7000. I'm Steve Moore. Welcome to Moneywise Live.
Well, Rob, this is an important topic — and the folks at Sound Mind Investing based in Louisville have an article on this in their latest newsletter, Traditional IRA vs. Roth: Which Maximizes Your Retirement Income? We'll tell you how to find that article a bit later. As I mentioned, our friend Mark Biller is here. He's the executive editor at Sound Mind Investing, but he's asked that, at least during the baseball season, that we introduce him as "the Louisville slugger."
Rob West: (chuckle) What an introduction, Mark. So glad to have you on Moneywise Live today.
Mark Biller: Thank you. Do I get walk-up music now if I'm being introduced that way —?
Steve Moore: We'll speak to the organist.
Mark Biller: — pick a song or something?
Rob West: Right. No peanuts though. (chuckle) So glad to have you along today, Mark.
This might seem to be, at face value, a very simple conversation because we often talk about the Roth IRA, but it's more complex than that, perhaps, as you think about approaching retirement and which a tax treatment is going to be more favorable or which combination may work best for you. We'll get into all of that. I think the first thing we need to understand what is the difference between the traditional and Roth IRA?
Mark Biller: Yeah, I guess the first thing, Rob, you know we're talking specifically about IRAs here today, but now that 401(k)s coming Roth and traditional flavors to a lot of what we're going to be discussing applies over there. But the first thing you have to understand about traditional versus Roth is we're talking about when you're going to pay your taxes.
So if you'd rather pay the taxes now, you can opt for Roth treatment. That's where you contribute dollars that have already been taxed today and then you're never going to pay tax on any of those earnings in the future. That's what we like about the Roth so much. But if you'd rather pay the taxes later, you can opt for traditional treatment that creates a tax benefit today because the dollars you contribute reduce your taxable income now. But the downside, of course, is you're going to pay tax on all of your withdrawals in the future.
Rob West: So it's really a question of "pay me now or pay me later" as far as taxes are concerned.
Mark Biller: Yeah, that's right. And so what that means is a lot of this discussion boils down to an educated guess regarding how your future tax rate is going to compare to your current tax rate. If you expect to be in a much higher tax bracket in retirement, you'd probably want to pay your taxes now at lower rates and opt for that Roth treatment. On the other hand, if you expect to be in a lower tax bracket in retirement, then it might be smarter to postpone your taxes until then by choosing the traditional. And, of course, the problem with all this is none of us really knows what tax rates are going to look like in the future, which complicates this whole decision-making process.
Rob West: All right, so in the article that you suggest in order to determine the best approach for each of us that we ask ourselves a few questions based on your financial situation to make this decision. And the first is, "Can you afford to contribute the maximum allowable amount to your IRA and or 401(k) each year?" Why is that important?
Mark Biller: That's because if you can afford to contribute the maximum, then choosing the Roth is almost always going to be the best choice because an after-tax Roth contribution is effectively bigger than a traditional contribution. Now, that's going to seem a little confusing because the contribution limits are the same on both types, but with a Roth, the taxes are already paid, so that whole contribution amount gets kept by you. Whereas with a traditional contribution, a portion of that amount is eventually going to be lost to taxes. I guess the best way to think of it is you're going to end up sharing part of that with the government — whereas with the Roth you keep it all.
Rob West: Well, we'll give an example of that after the break. I think that'll help folks understand this concept a little easier.
Rob West: Mark, you were saying that one of the decisions to make is whether you can make the full contribution because with a Roth you're, in effect, putting more money in. Give us an example to explain that.
Mark Biller: The easiest way I think the picture that is for somebody in the 22% tax bracket to fully fund or Roth IRA — right now there's a $6,000 contribution limit — but to fully fund a Roth IRA, it actually takes $7,692. That's the 6,000 that actually goes into the Roth and another $1,692 to pay the taxes for the Roth. And what we were saying before the break is with the Roth, you own that full $6,000 contribution.
Now with the traditional IRA, the contribution limit is the same. It's the same $6,000 but there instead of it being $6,000 plus tax money like we just said for the Roth, what you really have is $6,000 minus what's going to eventually be taken away to pay taxes.
So that's why we say if you can afford the maximum, the Roth is really bigger because you're not going to have to share that with the government down the road.
Rob West: All right. Question number two that you posed in this article at SoundMindInvesting.org is: "Do you expect to have plenty of other retirement income allowing you to postpone withdrawals beyond age 70-and-a-half or possibly leave the account intact for your heirs all together?" Help us think about that one.
Mark Biller: Yeah. The bottom line here, Rob, is if you've got other income, if you think you'll be able to postpone those withdrawals, then the Roth again looks better — because with the traditional, you have to start taking mandatory withdrawals at age 70-and-a-half. Roths don't have any mandatory requirements at all. A Roth 401(k) does, but you can get around that fairly simply by converting to a Roth IRA. Roth IRAs have no mandatory withdrawals, so that's another mark in favor of the Roth.
Rob West: So this would be somebody who's really thought about what it's going to take to fund lifestyle in retirement. They've looked at other sources of income — Social Security, perhaps other savings vehicles — and they're saying really this particular pool of money is money I don't plan to touch unless something changes, or it's money I'm going to ultimately pass on to my heirs. That would be coming down on the Roth side. All right, here's another one. "Do you expect to be in a higher tax bracket in retirement?"
Mark Biller: Yeah. So if you do expect to be in a higher tax bracket in retirement, then it would probably be best to take your tax lumps now and put the money in a Roth. And you know, a lot of people just expect tax rates to be generally higher across the board in the future — and that does cause a lot of people to lean towards the Roth. That's also a key reason why, you know, we often give advice to young people to fund Roth accounts cause they're normally in lower tax brackets now, and then you get the tax free earnings forever.
But this future tax rates question isn't quite as simple as it seems because with traditional contributions, the tax dollars that you save today are coming off the top of your income. In other words, you're saving at your highest marginal tax rate, but when you retire and you start withdrawing money from that IRA, unless you've got significant other income sources, which most retirees don't, then your withdrawals won't immediately be taxed at those highest tax rates. Instead, they're going to start filling in the lower tax brackets from the bottom up.
So I guess the best way to think of this is if you're a 55-year-old, say, and the 22% tax bracket today, you're saving on a traditional contribution at 22%. Now let's say 10 or 12 years from now when you retire, if you're only other income is Social Security, you're probably going to start paying tax on withdrawals from that IRA at just 10 or 12%. So you're saving 22% today, paying tax a decade down the road at 10 or 12% — that's a really attractive deal.
Steve Moore: We are very fortunate to have our good buddy Mark Biller back with us today from SoundMindInvesting.org. You really ought to check them out. They lots of great articles and resources on their web page. It's also where you can obtain a copy of The Sound Mind Investing Handbook — one of the best books you'll ever read. Again, SoundMindInvesting.org.
Let's go to Lincoln, Nebraska. Ron, how can we help you, sir?
Caller: I've just been listening to your IRA — Roth versus traditional. Yeah, I retired here a while back and I'll be 70 this year and start doing my RMDs next year. I met with my financial counselor yesterday and one other thought about the traditional that — well, the Roth didn't exist for mostof my career — I can give my charitable giving out of my MRDs instead of out of my — I can live entirely on my Social Security, and then we can go back to the standard deduction and take all of that. And that's fine, cause I'll give my charities over here. And I can give more out of the MRDs because it doesn't raise red flags with the IRS, and then giving more than a certain amount of my income.
Rob West: Yeah. You're talking, Ron, about the RMD, the Required Minimum Distribution?
Caller: Yes. Did I use a different initial? (chuckle)
Rob West: That's okay. Yeah. You were just saying MRD. I just wanted to clarify. But you're exactly right. You know, Mark, the qualified charitable distribution, uh, in proportion to what the government says you have to take out anyway as required minimum is a great opportunity if you don't need the money, as in Ron's case, and you want to bless your church or other ministry, right?
Mark Biller: Yeah, it absolutely is. And in addition to just the obvious benefits of being able to give that money to the charity, that also helps you a lot as a taxpayer, because that's going to keep your taxable income lower. And essentially these qualified charitable distributions allow you to send money directly from your IRA to the charity, which keeps it out of your taxable income — and that can help in terms of keeping other tax credits and deductions, your Social Security or Medicare. It has a whole range of downstream benefits to you as a taxpayer.
So that's a great point that Ron is making for people with traditional IRAs that have to take distributions but don't necessarily need that money right away. That's a great option.
Steve Moore: Ron, great information. We appreciate you calling on that. Thanks. Tallmadge, Ohio — Dorothy. We appreciate your patience, ma'am. What's on your mind?
Caller: Well, hi. We love your show. My question is, uh, I have a PERS I have about $17,000 in that and I think it earns 1%. I have an IRA and I have a 403(b) at work. The IRA was originally a 401(k) from a job in the 90s. My question is: Should I transfer that PERS money into that or should I let it sit there?
Rob West: Yeah, and for the benefit of our listeners, you're talking about a Public Employees Retirement System account. So you worked — uh, did work or do work for the government, is that right?
Caller: I worked, it was a county-owned hospital— and for three years I did. So I have three years of PERS.
Rob West: Yeah, very good. Mark, how should you think about these various retirement accounts?
Mark Biller: Yeah, so I guess the general principle, Dorothy, that we usually counsel people with is that we liked the option of consolidating accounts. One, it makes it easier to manage when you have fewer accounts. But more important than that, when you roll work accounts into an IRA, you typically have more flexibility in how you're going to manage that money — because most of the time, a 401(k), a government account, whatever it is, you're restricted in the number of options that you have.
Now, if you're perfectly happy with the options in the 401(k) and this PERS account that you're talking about or other employer type of account, then there's no need to move that to an IRA. And in some cases, it can actually be cheaper to leave it in the company account because the expense ratios of the funds tend to be fairly low in those accounts. But that's always something to double check: What are your options? What are you paying and expenses for those options? And then the big question is, how do you want to manage that money? If you want to be able to invest in things you don't have access to currently, then being able to roll that into an IRA is a great option.
Steve Moore: And "Louisville Slugger," sir, it's always an honor. Go get ‘em — bottom of the ninth. We'll be right back with more. This is Moneywise Live.