IRA vs. Roth IRA with JoAnn Huber
IRA vs. Roth IRA Show Notes
For many people, the 401(k) is their largest asset. However, there are several different types of 401(k) plans, each of which follows a different series of rules and regulations. Choosing the wrong type of 401(k) can have significant consequences in retirement – and can drastically affect your quality of life for years to come.
To make matters worse, when a typical financial advisor tells you about the differences between 401(k)s, it’s easy to feel your eyes glossing over as you get completely lost in the details.
That’s why we’re kicking off The Guided Retirement Show with a two-part series on this topic. Today, CERTIFIED FINANCIAL PLANNER® and CPA JoAnn Huber joins the podcast to share a high-level breakdown – with no technical mumbo jumbo or legalese – of how each of these financial vehicles is designed to work to your advantage.
In this podcast interview, you’ll learn:
- How the shift from pensions to 401(k)s in the late 1970s transferred the risk of having no money in retirement from employers to employees – and why it took years for people to trust the 401(k) as a reliable retirement vehicle.
- Why so many people think that the 401(k) will help put them in a lower tax bracket in retirement – and the reason this serious mistake often leads to the “Retirement Savings Time Bomb.”
- Why you should encourage your working children, especially if they’re still teenagers, to make Roth IRA contributions.
- How to easily calculate your taxable income.
- “The date you retire is halftime. You’ve got the rest of your life ahead of you.”
– Dean Barber
- “It’s not one or the other. It’s how do you use both to your benefit?”
– JoAnn Huber on IRAs
[00:00:15] Dean: Hello, everyone. Welcome to the first episode of the Guided Retirement Show. I’m Dean Barber, Managing Director at Modern Wealth Management in Kansas City. This podcast is all about the guided retirement system. We talked at Guided Retirement Show. Well, here’s the concept. When you go on a vacation, you may think, “Well this is a vacation that I can do on my own.” Maybe you’re just going to drive to the Grand Canyon and the only goal is to stand on the south rim of the Grand Canyon and just see it. Well, that’s something you can do on your own. But if you’re taking a trip to the Amazon as an example and you’ve never been there before and you know that the waters can be dangerous and there’s all kinds of crazy animals out there, you don’t know your way around. You’re going to be in the jungle. It would be a good idea to hire a guide. Your retirement is no different and that’s what we’re going to talk about here on the guided retirement show is all the things that you need to be aware of and we’re going to help you through this podcast, guide you through a very successful retirement. That’s our objective.
I’ve been in the financial services industry for almost 32 years. I’ve been doing financial planning for people that are getting near retirement, that are already retired, or just getting into that transition of retirement. One thing you have to remember is that retirement is the date you retire is just really half time. You get the rest of your life ahead of you and it’s what you do with your finances and the things that you decide to do from a tax perspective, from a risk management perspective. We go on and on throughout the Guided Retirement Show and we’re going to have several different topics where we get into a lot of different issues. Today’s show is going to be the first in a set of two shows that’s all going to be about IRAs versus Roth IRAs, and you might think, “Wow. How can you talk for that long about IRAs versus Roth IRAs?”
[00:02:13] Dean: I’ve got JoAnn Huber, CERTIFIED FINANCIAL PLANNER® and CPA, going to be joining us talking about the Roth IRA versus the traditional IRA. Anybody that is saving money into either one of those vehicles or even considering it needs to listen to this show because there are so many complicated rules that surround IRAs and Roth IRAs, and sometimes you might be making the wrong choice. Enjoy the show.
[00:02:45] Dean: All right, thanks for joining us for our discussion regarding Roth IRAs, Roth 401(k)s, traditional 401(k)s, JoAnn Huber, CPA, CERTIFIED FINANCIAL PLANNER®. So, JoAnn, I think one of the things that happens when people start talking about IRA or Roth IRA or a 401(k) is that you tend to get some pretty technical answers about what are these vehicles and I want to try to help people understand how these different vehicles really are geared to work to their advantage as opposed to just the technical mumbo-jumbo that goes on behind the scenes and here’s the way the tax code is written and this is what it says. My eyes gloss over when somebody talks about it that way and it loses a lot of people.
[00:03:40] JoAnn: Right. Because that’s not what people care about. Really, when I look at something like that, I want to know how is that going to help me or hurt me.
[00:03:48] Dean: Right. Yeah. Exactly. Right. So, I remember going back to 1978 when the 401(k) came in place and I was a young, young man in 1978. Obviously, it wasn’t quite out of high school yet and I remember it was I think 1979 or 1980, the company that my dad worked for formed – they’ve actually adopted a 401(k) plan and I would go out and hang out at his work and wanted to see what he was doing, how he was doing, and how did dad make money and, gosh, wouldn’t it be great someday if I could be a businessman like my dad and do all these great things. And so, I was a sponge and I was listening and the conversation, I’ll never forget this, came up in an after-hours just kind of sitting around chatting with his employees, and they started talking about this 401(k) thing.
And the amount of distrust that was there for this 401(k) thing which people really didn’t understand was unbelievable. It was like, “I’m not putting my money in this plan. I mean, yeah, they say they’re going to match some of what we put in but how do I know that I’m ever going to get the money out?” And so, I think it really took a long time from the time the 401(k) was born to when people finally said, “Hey, this might be something that’s pretty good,”
[00:05:13] JoAnn: Yeah. And that was when you think people were going to have enough pension to now they were having a 401(k) so they had this guaranteed income stream they were going to be receiving and now it was all on them with maybe getting some company match but like you said, they weren’t sure if that was actually going to happen.
[00:05:29] Dean: One of the things that it did was it really removed the risk of someone’s retirement success from the company and put it squarely onto the employee.
[00:05:40] JoAnn: Right. And I mean we had seen pensions that hadn’t made it and so it wasn’t as if there wasn’t any risk with the pensions but most people considered a pension a risk-free return of I worked all these years and now this is my reward.
[00:05:54] Dean: Right. What they didn’t understand was the behind-the-scenes the company itself was funding the pension, putting dollars into it, and then they had to use a life expectancy or an actuarial table to figure out how long does a person live past this age, how much money do we have to have to fund a certain dollar amount coming in each and every month? So, that 401(k) plan said, “Well, we’re not going to do the pension anymore, but we’ll put some money into this 401(k) and then it’s all your money. You can take cash. You can do whatever,” and it took a long time for that to catch on, but really I think it started to fuel the retirement savings that we see today and the 401(k) has now become one of the, if not the largest asset that most people have.
[00:06:40] JoAnn: Right. I mean, they’ve done a great job saving and people say I’m going to be in a low tax bracket when I retire with 401(k). I’m going to just keep putting money in there and that’s why it’s grown and then you look at the market growth we’ve had since the late 70s where it really had a lot of growth. It’s happened both organically and through the market.
[00:07:02] Dean: So, this leads this whole idea that you brought up a subject there. You said people believed that they would be in a lower tax bracket in retirement and that was one of what I think was the big sales pitch to the 401(k) plan. It was put your money into this 401(k) plan. We don’t include it in your income so you’re getting basically a tax deduction for every dollar you put in and it’s going to grow without any taxation all the way up until the time you take it out when you retire. Well, when you retire, you’re going to be in a lower tax bracket and that’s what people were told for years and years and years. And in fact, I see people making the mistake of falling to that same idea that, “I’m going to be in a lower tax bracket in retirement.” But I’ve worked with thousands of people that have transitioned from work into retirement and you know what, that whole idea that I’m going to be in a lower tax bracket in retirement hasn’t really played out because if you want the same lifestyle, that means you have to have the same income and if you’ve got the same income, you’re in the same tax bracket and in some cases may be higher.
[00:08:08] JoAnn: Right. And I think people have to look at that and say, “Well, I’m kind of thankful that I’m not in that lower tax bracket,” because they do have the ability to take out more from their 401(k) to fund that lifestyle so they can go do those things they want to do, make memories and not just sit at home on the couch.
[00:08:23] Dean: Well, sure. You want to have the money but again it’s created what our good friend, Ed Slott, who’s considered by many to be America’s IRA expert has said, “It is the retirement savings timebomb,” and the timebomb is the IRA or 401(k). They both fall under that same section of the IRS code.
[00:08:44] JoAnn: I think it’s important to explain what he means by that timebomb is that at some point when you take that money out, you have to pay the taxes. And so, that’s that explosion that’s going to happen because when you have that 401(k) or that IRA, only a portion of that belongs to you and the rest is going to go to the government. It’s just a matter when they get to collect their portion.
[00:09:04] Dean: Right. So, that’s exactly right. So, it is a timebomb and in fact, we would do this on a different podcast when we talk about required minimum distributions but I think it’s worth mentioning the required minimum distributions here because I want to lead around to we’re given some background on the IRA, on the 401(k), we’re going to get to why people chose to put their money in there but now why would a person choose to utilize a Roth version of the 401(k) versus a traditional version or why would they choose a Roth IRA over a traditional IRA? And one of the reasons is this provision that hits when a person turns 70.5, they have to then make what are called a required minimum distribution. They’ve got to start taking money out of those retirement accounts and if you don’t need the money because you’re continuing to work, you still got to pull it out of your IRA. You may not have to pull it out your 401(k).
But I’ve worked with people, JoAnn, that worked into their late 60s and all the sudden they retire, and they’ve got, you know, in one example I had a couple that had a pension. They were both getting Social Security. They had zero debt and they’re sitting there going, “Well, you know what, I got enough money to live on right here,” and I said, “Well, it’s too bad that you have enough to live on because this money that you have and the 401(k) now gets to go to an IRA, you got required minimum distributions,” and all of the sudden, what we saw happen was that their tax burden in retirement was far greater than it was while they’re working. As a matter of fact, in this particular couple’s example, their entire Social Security checks combined had to go to federal and state taxes because of the requirement of distributions on their IRA. That’s the retirement savings timebomb.
[00:10:55] JoAnn: Right. And in their situation, they’re probably saying, “We’re paying more in taxes than we made a lot of years when we were working.”
[00:11:01] Dean: Right. And their comment is, “Gosh, I wish we could just leave this money in because we really love to see our kids get this money or our grandkids get this money.” Unfortunately, that provision of the tax code that surrounds the IRAs, that required minimum distribution, doesn’t allow you to just keep the money in there. So, what was introduced in 1997 was I think perhaps, in my opinion, the very best section of the tax code that has ever been written. It was written by Senator Roth and so, therefore, the code was called the Roth IRA. So, this is all after Senator Roth and I think a lot of people really know that that was the actual senator’s name that introduced the Roth IRA but it was a brilliant concept because it allows people to put money into the Roth IRA or the Roth 401(k) without any deduction when the money goes in, but then once it starts growing, there’s no taxes due as it’s growing in the cool part is there’s no taxes due when you start taking the money out and there’s no required minimum distribution. Even if there was, it’s not a taxable event.
[00:12:09] JoAnn: Right. And that’s what’s so important to point out is there’s not that required minimum distribution so that allows that money to stay invested which the compound growth can happen and so you can get a very sizable asset to leave to your heirs, and the other benefit is if you have a surviving spouse, it gives some flexibility or even if you’re still married, you have some flexibility in determining how you’re taking your money so you can control your taxes a little bit better in retirement. I like the story you have shared before about comparing to farming.
[00:12:42] Dean: Are you going to tell that story?
[00:12:42] JoAnn: Yeah. Go ahead and tell that story.
[00:12:43] Dean: So, the Roth IRA I think if you compare to a traditional IRA, pretty much it doesn’t matter where you live in the country. We’ve got farmers all across the United States and when a farmer goes to plant the seed for their crops, they get a tax deduction when they plant that seed for the cost of the seed. When the crop grows and they harvest, they wind up paying taxes on the entire harvest and that is the traditional IRA, the traditional 401(k). So, the idea is you get a little deduction when the money goes in. You get to defer the taxes. It grows. But when it comes out, it’s all taxable. The Roth IRA is really just the opposite of that. It’s like taking the seed and saying, “I want to pay taxes on that seed before I plant,” and then the crop grows, and I get the entire harvest tax-free. Now, if a farmer had the option to choose the version where they paid taxes on the see or got the deduction on the seed, what you think they’d rather do?
[00:13:47] JoAnn: I think I’d rather pay on the seed.
[00:13:49] Dean: That’s right because you’re paying taxes on a much smaller amount. So, the Roth IRA was introduced in 1997 and it was introduced with some pretty interesting caveats in that first year. As a matter of fact, they were really encouraging people to move money from the traditional over to the Roth and that there was born the Roth conversion. So, first of all, the Roth IRA the contribution limits to that were the same as the traditional IRA. Your income limits at that time were the same as the traditional IRA so you could choose, “Do I want to put my money and after I paid taxes on it and let the accumulation grow and I get my money tax-free later or do I want a little deduction when I put my money and then pay taxes on the whole thing later on?” Right. From day one to the time you retire and start taking money out, there’s virtually no difference between the two. It’s all about do you get a deduction when you put it in and then how much tax do you pay when you take it out?
So, the Roth IRA was big, but they knew that if people really want to get money into that Roth IRA, they needed to give them an incentive. So, in that very first year, they allowed people to make a conversion from their traditional IRA to the Roth IRA and now they have to pay taxes on that when they do the conversion. But let’s just say that for an example somebody had $100,000 in an IRA in 1997. They could move that entire $100,000 from the traditional IRA over to the Roth in 1997, and it would only increase their taxable income by $20,000 each year for five years. So, in other words, they got to spread that income that was due to the conversion out over that five-year period so in most cases, it didn’t kick people up into a higher bracket. And I encouraged back in 1997 a good number of my clients who I thought were in the right position to do that to take advantage of that one-time conversion where you could spread the tax burden out over a five-year period.
[00:15:51] Dean: And those people are really happy today. Some of those people are no longer with us, but their beneficiaries are really happy because they now have an inherited Roth IRA that’s kicking out tax-free income for the ultimate beneficiary, the kids and the grandkids of those people.
[00:16:05] JoAnn: Yes. So, if you want the best tax-free asset to inherit, either life insurance or the Roth IRA.
[00:16:14] Dean: Yes. So, that Roth IRA I think you and I would both agree is a great vehicle for saving money. In fact, I think anybody that qualifies to put money in a Roth doesn’t put money in a Roth at some point in time is really missing the boat.
[00:16:30] JoAnn: Right and I mean I’ve encouraged my children to put money into their Roth IRA. So, if you have a teenager that’s doing a part-time job babysitting or something and they’re earning money, they’re eligible to contribute to a Roth IRA as well. So, if you think about it, you have some of those teenagers that are earning money and they’re probably going to be in a 0% tax bracket. They can put that money into the Roth and then they never paid tax on it.
[00:16:56] Dean: Ever.
[00:16:56] JoAnn: Right. So, so you can’t be at zero.
[00:16:59] Dean: And think about the 30 or 40 or 50 years of compound growth on that money and what that could actually do, that’d be amazing for the young people to get that Roth started early.
[00:17:09] JoAnn: You know and it’s not that the kid has to put the money in. A parent can put the money in for him or a grandparent or something so there’s a way to encourage your child and teach them about saving for retirement from a very early age.
[00:17:21] Dean: Yeah. No question about it. That’s a great opportunity for sure. So, let’s continue on this whole idea of the Roth versus the traditional because there’s been heavy debate across our industry. I think from the tax professional’s industry, the CPAs, the enrolled agents and things like that, and then also the financial planning industry as to which one of these two things is better. Is it the traditional IRA? Is it the Roth IRA? And what’s happened is I think that people have tried to make a really simple answer out of that by creating a spreadsheet that they call a breakeven calculator.
[00:18:10] JoAnn: I mean, you can just google it and there’s calculators out there but that’s not going to give you the true answer for you.
[00:18:16] Dean: So, I need you to explain why that doesn’t give the true answer because I think so many people, they’ll do exactly what you said. We’ll google Roth versus traditional IRA. Which one should I do? And what you’re going to see is multiple calculators that’ll try to put side-by-side the Roth versus the traditional and the answer that you get on that side-by-side calculator as you said is not the right answer.
[00:18:38] JoAnn: Right. Because all it’s doing is looking at it in a vacuum. You have your traditional IRA or your Roth IRA and it’s comparing those two things, but it’s not considering what other assets do you have and then when are you going to need the money? How long are you going to live? Are you going to invest it the same way if it’s the Roth or the traditional? What’s going to happen when you start taking required minimum distributions? What’s going to be your tax rate then? What’s your tax rate today? So, those are just a few of the things that are going to factor in and say what’s really best. So, when we look at that decision and people will say, “Well, that’s really simple.” It’s not. You’ve really got a look at the overall financial plan. What are all the sources of income they’re going to have and how are they going to be taking that money out?
[00:19:26] Dean: So, you’re talking about a lot. I mean, you just said so many different things right there that I think people at that point might just throw their hands up in the air and go, “Well, I don’t know all of those things so how can I possibly make the right decision?” And because it is complicated, a lot of people will succumb to one of two things. A leader say, “Well, forget about it. I’m just going to do this breakeven calculator. I’ll make my decision that way,” or I’ll just guess because the other stuff makes my head hurt. I don’t want to think about it.
[00:19:58] JoAnn: Well, they have a 50-50 chance of getting it right.
[00:20:02] Dean: Okay. So, toss a coin and figure out what we’re going to do. Okay. Let’s take a quick break. This is the Guided Retirement Show. I’m Dean Barber. We’ll be right back.
[00:20:13] Female: At some point in everyone’s life you have to go to school because let’s face it, a good education is important and just because you’re nearing retirement age or you’re already there, it doesn’t mean the learning stops. One of the easiest ways to learn about retirement is that Modern Wealth Management’s education center. There, you’ll find things to read, to watch and to listen to about important retirement topics. So, go to BarberFinancialGroup.com. Click on the menu drop down. It’s in the upper right-hand corner and select Education Center. There you can download and read our Social Security checklist, watch Dean Barber’s latest video on the current state of the markets, or listen to an audio recording about tax reduction strategies and so much more. There’s no cost. Just sign up for access at BarberFinancialGroup.com. It’s as simple as that. Besides, there’s no tests, no textbooks, and I promise not to move your seat, even if you talk too much. There’s so much to learn about retirement. Just go to BarberFinancialGroup.com. Click on the menu drop down and select Education Center.
[00:21:27] Dean: That whole idea that I’m going to be in a lower tax bracket in retirement hasn’t really played out because if you want the same lifestyle, that means you have to have the same income and if you got the same income, you’re in the same tax bracket and in some cases may be higher.
[00:21:39] JoAnn: Right. And I think people have to look at that and say, “Well, I’m kind of thankful that I’m not in that lower tax bracket because they do have the ability to take out more from their 401(k) to fund that lifestyle so they can go do those things they want to do, make memories.
[00:22:12] Dean: We’re back. So, you say there’s no easy way to answer whether someone should do a traditional versus Roth. Let me pose a scenario for you. I have a 26-year-old son, who is today earning $65,000 year. He’s very young in his career. He is a dedicated saver and he has money in the bank. He’s got his cash reserves and he’s adding money to his 401(k) each year. He’s got enough money that he can fund an IRA each year. Would it be a simple answer for him whether he should do the traditional IRA or the Roth IRA?
[00:22:58] JoAnn: See, in my mind, I think his would be a simple situation.
[00:23:00] Dean: Okay. Why?
[00:23:01] JoAnn: Because he’s young. He’s in a pretty low tax bracket. So, put it in the Roth where he is not going to pay a whole lot of tax on it today but yet he has his whole lifetime and chances are his income is going to go up dramatically because he’s 26 and he’s a hard worker, so his earning potential is unlimited and so that’s going to compound and grow. So, if he puts it in right now, that 5,500 even if he doesn’t get the tax deduction, think of the years that that’s going to be able to grow until he reaches retirement.
[00:23:34] Dean: And then he could pull it out tax-free.
[00:23:36] JoAnn: Right.
[00:23:37] Dean: Now, there’s other ways to get your money out of the Roth IRA prior to retirement.
[00:23:45] JoAnn: Right. There are a few exceptions where you can take it out. One thing that’s important to know is if you take money out of a Roth IRA or a traditional IRA before age 59.5, then it’s subject to an early withdrawal penalty on the taxable amount.
[00:24:00] Dean: So, even if it’s a Roth IRA, there’s going to be an early withdrawal penalty, which is 10%.
[00:24:03] JoAnn: There might be, but the Roth is actually a special saving vehicle because you can put, take out your contributions at any time. It’s only when you get to that taking out the earnings piece where you have to start worrying about paying taxes if you take it out before age 59.5.
[00:24:19] Dean: All right. So, let’s give an example and let’s use my son again. He’s 26 years old. He wants to fund a Roth IRA every single year and so he starts putting in $5,500 a year into the Roth IRAs, putting in his maximum amount in and he goes along and let’s say he just does that for the next 20 years. And so, he’s put in $110,000. He got hundred $110,000 of contributions into the Roth IRA. Let’s say that two years from now he’s married and has a baby. So, 18 years from the time he gets married and has a baby, he’s going to have a child entering college. So, what you’re saying is if he wanted to, he could pull the contribution portion of that Roth IRA out, no taxes due. It’s money that’s there and he can start paying for college education with that.
[00:25:18] JoAnn: Right. If he needs to.
[00:25:20] Dean: If he needs to but that would be an option. That would be an example of why somebody might get into that and then all the earnings that have grown on that thing over the last 20 years they stay in the Roth IRA. As long as he doesn’t take the earnings portion…
[00:25:32] JoAnn: He has no tax.
[00:25:33] Dean: That’s tax-free when he takes it out at retirement.
[00:25:35] JoAnn: Right.
[00:25:35] Dean: As long as he’s reached 59.5 and it’s been in for five years. So, see, that is really exciting, and I think it’s a great thing to do. So, if you’re a young person and the example of my son, I would agree. That’s very, very straightforward. I’m going to make it a little more complicated for you. Did you want to say something?
[00:25:53] JoAnn: I was going to say that where it gets tricky is when you get older and I think people kind of in those middle years where you’re a high earner where you contribute.
[00:26:02] Dean: So, I’m going to do two ends of the spectrum and then we’ll get back to the kind of the middle-of-the-road people or the middle-aged people. So, let’s say that we are visiting with someone who is 60 years old. They plan to retire in the next three to five years. At the age of 60, they’re at the peak earnings of their career. They make more money than they’ve ever made in their life. Chances are that at that point in time if they’ve been a good steward of their money, they probably have very little debt, they have huge savings capacity, and they have the ability to put money into not only an IRA but they also have the ability to put money into a 401(k).
And in 2006, the Roth 401(k) was born which allowed people to put money into their 401(k) after taxes just like the Roth IRA. No earnings limits on that. You can earn as much money as you want and still use a Roth 401(k) and you pay taxes on before it goes in and then it grows and you get to pull it out tax-free. So, if I’m two to three or four or five years out from retirement and I’m in my peak earning years, do I use the Roth portion of my 401(k) or am I better off at that time using the traditional portion of my 401(k) and getting a tax deduction now.
[00:27:32] JoAnn: And this is where it gets really complicated and I’d say it’s going to depend on what else you have. So, if we have someone who has put a lot of money into tax-deferred and we know that once they hit 70.5, they’re going to have a really high required minimum distribution. We might not want to be adding to that amount. And so, even though they’re contributing at a high tax rate, it may be that when they retire, they’re going to be in that high tax rates still and so we’d want to look at it and say, “What makes sense for you?” I mean the first thought is, “Oh, definitely they would want to put it into the traditional,” and then we can do a Roth conversion afterwards but…
[00:28:11] Dean: Well, we haven’t talked about what a Roth conversion is.
[00:28:13] JoAnn: Okay. Well, so…
[00:28:16] Dean: So, we’re going to need to explain the Roth conversion before we start talking about these intricacies.
[00:28:20] JoAnn: Okay. You want to explain it or would you like me to go?
[00:28:24] Dean: Go ahead.
[00:28:24] JoAnn: Okay. So, a Roth conversion is where you take money from your traditional IRA and pay tax on it in the year that you move it over to a Roth IRA and that’s called the Roth conversion and there’s no age restriction. There’s no income limits. So, anybody can go ahead and do that Roth conversion, to move that money from the traditional to the Roth. But you have to make sure that you’re doing it in a smart manner that you’re not just moving everything and accelerating all of the taxation.
[00:28:54] Dean: All right. So, if I do a Roth conversion, how much do I have to convert?
[00:28:59] JoAnn: You can it convert as much as you want to.
[00:29:02] Dean: I can convert as little as I want to?
[00:29:02] JoAnn: You can convert as little as you want.
[00:29:05] Dean: How would I make that decision?
[00:29:06] JoAnn: You know, we spend a lot of time working with people and seeing how much should I convert because for a lot of people Roth conversion makes a lot of sense and what we’ll typically do is look at what’s your current tax bracket and if we have somebody that’s in that 12% tax bracket, a lot of times we’ll look at what can we convert to get up to the top of that 12% tax bracket.
[00:29:25] Dean: All right. Explain what you mean there. So, the 12% tax bracket, sitting here the latter part of 2018, how do I know I’m going to be in that 12% tax bracket? What’s my limit on….
[00:29:41] JoAnn: The taxable income is $77,400.
[00:29:44] Dean: All right. That’s taxable income so we got to explain there’s a difference between taxable income and income and adjusted gross income and all that. So, can we really quickly…
[00:29:52] JoAnn: So, let’s just make it really simple so…
[00:29:54] Dean: Let’s just say, for example, I got a married couple and they’re earning $120,000 a year. Each one of them has a $60,000 salary. Let’s just make it simple. Each person has a $60,000 salary. That’s my gross income. Okay. What is my taxable income and how do you arrive at that? How can a person that is listening to us right now really simply calculate what is my taxable income off of my 120,000?
[00:30:30] JoAnn: So, if they have 120, then their taxable income is going to be 96,000 and the way we get to that is say we have 120,000 and then they will, you know, assume they’re going to take the standard deduction which will be 24,000 for 2018 and that leaves him with taxable income of 96,000.
[00:30:48] Dean: And what if this couple is working and they have an HSA plan or they have a 401(k) plan that they’re contributing to? Now, what’s my taxable income?
[00:30:57] JoAnn: So, it’s going to depend on how much you’re contributing to that. So, the HSA whatever amount you contribute to that HSA subject to the limitations would be subtracted from your adjusted gross income and then if you make a contribution to a traditional 401(k), that would be subtracted as well. So, let’s just assume we have that same couple that they each put $10,000 into their traditional 401(k), now, we’re down to having taxable income of 76,000 and that puts them right at the top of the 12% bracket.
[00:31:32] Dean: Right. So, if they didn’t contribute to a 401(k) and get the deduction at that point then they would’ve paid taxes on that additional $20,000 at what rate?
[00:31:45] JoAnn: At 22%.
[00:31:47] Dean: All right. So, there’s an example where so this would be really simple math in my head. If we put combined as a couple $20,000 into a deductible 401(k), the traditional 401(k) and I got a deduction on my income and it’s 22% taxes, am I hearing you right that I just lowered my tax bill in that year by $4,400?
[00:32:15] JoAnn: You did.
[00:32:15] Dean: And that was simple.
[00:32:18] JoAnn: Right.
[00:32:18] Dean: I’ve lowered my tax bill by $4,400 by using the traditional 401(k) in that example. I kept everything in the 12% bracket.
[00:32:30] JoAnn: You’re right.
[00:32:32] Dean: So, if I’m that couple making 120 and I got that income of what did you say? 76? What’s my total federal tax liability going to be?
[00:32:40] JoAnn: It’s going to be 12% of that. I can’t do math very well.
[00:32:45] Dean: So, it’s going to be below $8,500?
[00:32:47] JoAnn: Right. So, I paid $8,500 in federal tax on $120,000 of income. I mean, that to me feels like a lot more like a 6% tax rate.
[00:32:56] JoAnn: Right. But what you have to look at is what tax rate are they going to pay on that money when it comes out? And that’s where it gets complicated is if they’re going to be in that 22% rate when they take it out or are they going to be up in a 35% tax? So, that’s why it’s really not as simple as…
[00:33:16] Dean: Okay. But what if I did this? What if I took the $4,400 in tax savings and I wouldn’t put that $4,400 into a Roth IRA?
[00:33:28] JoAnn: Right. So, now you’re getting the best of both worlds, which is what we have to get people to think about. It’s not one or the other. It’s how do you use both of them to your benefit and work them together because what we really want to have when somebody gets to retirement is you want to have money that you can choose where to take it from. So, we usually will talk about having three different buckets where we’ll have a taxable account and that’s going to be what you have in your bank account. If you have a brokerage account that’s considered your taxable account and then we had tax-deferred, and that’s that IRA, the 401(k) that we’ve been talking about where you get the tax deduction going in and then you pay tax on it coming out. And then the final third bucket is that tax rate which is the Roth. So, if we have money in all three buckets, that gives us flexibility and then we’re able to start controlling our taxes in retirement.
[00:34:21] Dean: All right. I want to break this down a little simpler.
[00:34:24] JoAnn: Okay.
[00:34:24] Dean: All right. I’m going to go back to that same couple $60,000 a year each. They’re earning $120,000 a year. They decide that they’re going to do $10,000 apiece into their 401(k) plan. Okay. So, they took $20,000 out of their earnings but it only reduced their income by little over 15,000, by 15,600 because it saved them 4,400 in taxes, right? If they were really committed to saving that full 20,000, they could save the 20,000 plus they could take the 4,400 that they saved in taxes and put it into a Roth. So, now all the sudden the way that I look at this and help me understand if I’m right or not looking at it this way is I just got $24,400 saved for retirement and I only reduced my income by $20,000. Am I right?
[00:35:25] JoAnn: Right.
[00:35:27] Dean: So, now my calculation gets more complicated but first I’m going to look at that and I’m going to go, “Okay. I can reduce my income by 20,000. I get 24,400 invested. 20,000 I was going to grow tax-deferred. I want to pay taxes on some point in the future, but that 4,400 now is going to grow tax-free forever. So, I reduce my income by 20. I got 24,000 invested. So, help me understand on the Roth 401(k) piece then. If all I did was the Roth 401(k), I could each in this example, each one of this couple could do the same $10,000 contribution to the Roth 401(k), their income is going to reduce by the same $20,000. There’s no tax savings to invest. So, what I have to measure then is I have to measure what’s going to be better between now and the time I retire. Is that the 20,000 that’s in the Roth 401(k) that all is going to grow tax-free or is it the 20,000 in the tax-deferred traditional 401(k) plus the 4,400 in the Roth IRA, which one of those two options gives me the most income after taxes in retirement?
[00:36:42] JoAnn: Right and that’s what we’re looking at?
[00:36:43] Dean: Where’s the calculator to do that online?
[00:36:46] JoAnn: I haven’t found it yet.
[00:36:47] Dean: So, it doesn’t exist. My point is that that’s really the level of detail that somebody’s going to need to be able to do, and in order to be able to do that you got to be able to do some forward-looking planning to say, “Well, okay, how much is that traditional 401(k) likely to be worth? What’s your Social Security going to be? Are there going to be pensions, etcetera? What other sources of income might be there in retirement so that we can arrive at an approximate tax bracket that that person is going to be in retirement? And only if we do that, can we measure which one’s going to be more effective, the traditional or the Roth?
[00:37:29] JoAnn: That’s so true. You know, when I was recently talking to somebody that asked me that same question in your situation that you posed where there are a couple of years out from retirement, they’re trying to figure out where do we contribute and then they’re like, “Well, the tax rates are really low. Do I do a Roth conversion this year?” And intuitively, you think, well, the rates are low. It might make sense but when we look at their whole plan, it actually puts them in a worse situation to do a Roth conversion at this point rather than waiting until they retire. And so, there are so many moving pieces and you can’t just make that quick little guess. You really do need to run the numbers because you might end up hurting yourself. And when I talk about hurting yourself, I mean, you might not have as much money to spend for retirement or to even spend today to do those things that you really want to do.
[00:38:18] Dean: Thanks for taking the time to join us here on the Guided Retirement Show. I’m Dean Barber, Founder, Managing Director at Modern Wealth Management. I know there’s a lot of podcasts out there and I want to take the time to thank you for listening to the Guided Retirement Show. On our next show, our next episode we are going to continue with IRAs, Roth IRAs, Roth 401(k)s with JoAnn Huber talking about how to appropriately put these things into your overall financial plan. And if you want to get an opportunity to take a look at a piece that JoAnn authored, it’s called Tax Reduction Strategies, you can get a copy of that or our retirement plan checklist or really both of these things, all you got to do is go to GuidedRetirementShow.com/1. Make sure you subscribe to the Guided Retirement Show, share it with a friend, and make sure to rate us on your favorite podcast app.
Investment advisory service is offered through Modern Wealth Management, an SEC-registered investment advisor.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.