Traditional vs Roth IRA

Full Transcript:

Ryan: There's always been this idea that yes, let's go ahead and contribute to these accounts. Let's get the tax deduction now because the idea's in retirement, you'll be in a lower tax bracket and that's true for some people and it's not true for others.

Announcer: When it comes to financial planning, you need to cut through the jargon so that you can understand how to achieve your own retirement success. This is Candid Conversations: Retirement Talk with Ryan Cravitz of Cravitz Financial & Insurance Solutions.

Ben: Well, hello and welcome in to Candid Conversations: Retirement Talk with Ryan Cravitz. I am Ben. Of course, he is Ryan Cravitz over at Cravitz Financial there in Irvine, California. Got a good show for you today, traditional versus Roth. Trying to help you understand the difference between these two types of accounts. Ryan, is this something that you have to discuss quite a bit with clients and work through with them?

Ryan: It is. I find that there's some areas of confusion here, so I think today we'll be able to clear it up.

Ben: Yeah, that's the goal today is, I think a lot of people don't have a totally clear picture on whether they should be contributing to a traditional IRA or Roth IRA. So today we want to really help you determine what's going to be best for you here on the podcast. And again, if you have questions, CravitzFinancial.com is a website and you can also call 714 462 9155. And of course you always want to sit down with a professional to figure out exactly what's going to work best for you and where you should be contributing your money. But hopefully today's episode will help give you a better idea and give you a place to start when having that conversation with your advisor. So as we lead this thing off, Ryan, let's start with really the differences between these two types of accounts, the traditional and the Roth IRA.

Ryan: I think the first thing to know is that neither a traditional IRA or a Roth IRA is an investment in and of itself. All they are is accounts. And actually technically, if you go on the IRS website which you'll see under IRA, is individual retirement arrangement. Now we often just say individual retirement account. In fact, I think individual retirement account sounds better, but the other reality is that for the most part we just say IR. The big differences or the main differences really between the two is just how your money is taxed. With a traditional IRA, when you contribute to it, you can get a tax deduction no matter how high your income is. There's no limit. You could be making a million dollars a year, wouldn't matter. You could still get that tax deduction as long as neither you or your spouse has access to and is covered by a retirement plan such as a 401(k) plan at work.

Now, if you or your spouse, assuming you're married of course, have access to a retirement plan at work, then depending on your income you could either get just a partial tax deduction or you may not get any tax deduction at all. Now, if you aren't going to get a tax deduction, you really need to consider whether it makes sense to make the contribution at all. Perhaps it would make more sense to just invest it in a taxable brokerage account. The tax rates for long-term capital gains and qualified dividends may very well be more favorable to you than having to pay tax on the growth of that money at ordinary income tax rates. All that said, for the most part, the idea and the benefit of contributing to a traditional IRA is to get the tax deduction. Again, assuming you qualify for it.

Now, Roth IRA is basically the opposite. At the Roth IRA, you're going to pay the taxes upfront, and then after you've paid the taxes, then you can go ahead and contribute that money that you've already paid taxes on to the Roth IRA and again, it will also grow tax deferred, and then in the future, as long as... There are some rules here again. You have to wait at least five years, and have to be older than 59 and a half. Once you go to access the money, you can take what's called a qualified distribution from it, and then when you do that, money is tax free. So again, in a nutshell, and there's some different rules and parameters as I'm mentioning around this, traditional IRA, get the tax deduction now gross tax deferred. In the future when you go to pull out the money, you have to pay taxes on that money. Roth IRA, the opposite. Pay taxes now. Let the money grow tax deferred, and then in the future you can access that money tax free.

Ben: Okay, so it's all tax related, is the main core difference between these two types of accounts? So when you look at the way people invest, I think it's been for a number of years, traditional IRA's been really the key vehicle, maybe the major vehicle that people use to save for retirement. Why do you think people have contributed much more to that traditional IRA rather than utilizing the Roth over the course of their life?

Ryan: Well, I think that there's a few different reasons. Number one, the desire to get a tax deduction now and to go ahead and save money on your taxes right now today is appealing. That's one of the reasons. And another reason is, and really this is why there's a lot more money in traditional IRAs, is that people have contributed to pre-tax 401(k) accounts and other types of company sponsored retirement plans and then have rolled over that money into traditional IRAs. But there's always been this idea that yes, let's go ahead and contribute to these accounts. Let's get the tax deduction now because the idea's in retirement you'll be in a lower tax bracket, and that's true for some people and it's not true for others.

Ben: Okay. That makes a lot of sense. What about the Roth can make it so powerful though? I know it's something that people are leveraging more and more now, but why can it be so powerful for someone trying to position themselves for retirement?

Ryan: I love Roth IRAs, and the reason why again, because when you go to access that money it's all completely tax free. But another really big reason I like the Roth IRA is the flexibility that it gives you. So with a traditional IRA, when you reach age 72, you're required to take out what's called required minimum distributions, just called RMDs oftentimes for short. And so that's a certain amount of money that you're required to take out each year. Whether you want to or not, the IRS makes you because they want to have you pay taxes on that money. That money's never been taxed.

But with a Roth IRA, there are no RMDs, so there are no required minimum distribution. So if you never want to take money out of that, you never have to. You can continue to let that grow. One thing that I should mention, because this is an area of confusion I know for some, is that with a Roth 401(k), which not everyone has access to, but some people do through their job... With a Roth 401(k), there are required minimum distributions. That's not really a big deal because at some point you can always look at rolling that over to a Roth IRA, but you do need to be aware of that, that the rules are a little bit different there.

Ben: For someone that maybe isn't sure if they have a Roth 401(k), is that just something you ask about with your company?

Ryan: Yes, it is. In order to know whether you do have that Roth option available, you can talk either, typically HR. You can also get the summary plan description and it'll show in there if that's an option that's available to you.

Ben: Okay. Good to know. All right, so we got a pretty good breakdown of what's what. Let's talk a little bit about who can maybe benefit from each of these types of investments. Let's start off... And again, we know it all depends, and everybody's situation's different. But let's start off, let's give an example of maybe someone who should choose that Roth option over the traditional IRA.

Ryan: Definitely somebody that's younger, maybe just getting started in their career. They contribute to a traditional IRA. Maybe they won't save that much in taxes, but in the future, if in fact tax rates do go up, which I do believe that they will, they'll have to pay taxes on all the growth at that point, and it just may not make sense. Other times to consider this are if you're getting close to retirement and you've got a lot of money that's been accumulated in traditional IRAs or pre-tax 401(k)s, other types of pre-tax retirement accounts like this, having that flexibility so you're getting some tax diversification... And we talk about diversification with investments, but it's important too to have diversification with your taxes. Having money in a Roth IRA as well gives you some more flexibility so that you can decide... Again, there's no RMDs on Roth IRAs, so you can pick and choose when you're going to access that money. So obviously to a Roth, there's a lot of benefits.

Ben: Well, when you break it down, it just seems like the Roth is almost a no-brainer for a lot of people. So I'm curious, what situations would someone choose to use the traditional instead of a Roth.

Ryan: Contributing to a Roth IRA is definitely not for everybody. Right? Let's say you're 60 years old, you're still working, you're in your peak earning years and you are thinking about contributing to a Roth IRA, it may not make sense for you because the benefit of getting that tax deduction by contributing to the traditional IRA might actually be more advantageous for you. Now, if you're like me, you probably think that tax rates are going to increase in the future. And again, I definitely believe that tax rates will go up in the future, but it doesn't necessarily mean that it's going to affect you. In other words, it doesn't mean that you'll have to pay more in taxes. It all depends on what you have saved, how much you have saved, where it's saved, how it's going to be taxed and all that sort of thing.

Let me give you just a real simple example of, for a married couple that's maybe living on... They got social security for a total $50,000 a year combined between the husband and the wife, and then maybe they're going to withdraw another $50,000 from their IRA account. Well, that's 100,000 of income. And on $100,000 of income, many people are shocked to know that their total taxes may only be $7,000. Again, it could be more or less, this is just rough numbers, but that's a 7% effective tax rate. And part of that has to do with how social security is taxed. So the point is that everyone's situation is different.

Ben: Yeah. And that's the bottom line... Everybody's going to require a different plan to get to where you want to go. Maybe a traditional is the best path. Maybe it is the Roth IRA, that's the best path. But bottom line, you want to have a plan for whatever strategy you do determine to use. So of course, if you haven't sat down with someone, you can always get in touch with Ryan CravitzFinancial.com. That is the website. And if you want to call him, you can do so at 714 462 9155. I think either way though, Ryan, you need to be taking advantage of these IRAs in order to be saving for retirement, whichever path you choose.

Ryan: Absolutely.

Ben: Alright, well that'll do it for us here on Candid Conversations: Retirement Talk with Ryan Cravitz. We appreciate your insight and time as always, and look forward to doing it again soon.