PODCAST EPISODE 282 – IRA vs. Roth What’s The Difference?

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Hello, and welcome to the sound financial group podcast. My name is Paul Adams, I’m your host today and I’m your only host today is Corey is not with us out on some family time. But I am excited about this episode today because we’re gonna go over the very basic differences between a traditional IRA and a Roth IRA and why you might want to choose one over the other. And we’re also going to touch on why an IRA doesn’t have any tax advantages to begin with. So let’s jump right in. Let’s start by talking about our regular traditional IRA, you can see that we could put in $650,000 a year now, we are going to talk about it as if it is deductible right now. But something as simple as having a 401 K through work can make this nondeductible, it can also be impacted by income limits, etc.

We’re not going to get as deep into that today, just know that I’m going to show the IRA in its best possible light both that you can contribute and that it’s fully tax deductible when comparing it to a Roth IRA. So to any extent that your traditional IRA is not tax-deductible, it probably turns out worse than what we’re going to show you today. So if you put in $6,500 A year into your IRA, which we’re representing by this cute little box, starting at age 40, and you put in that same $6,500 per year, earn a 7% return every year, over 25 years age 40 to 65, you get $439,000. Now, let’s just assume that you’re in about the 25% tax rate all the years that you’re putting the money in, meaning you’re putting money in every single year, but part of the money belongs to the IRS every year you do it. One easy way to visualize that might be something like 25% of the box that you’re putting your money into is owned by the IRS. That’s under current tax rules. Of course, if you took it out early, they instantly owe own 35% Simply because we now have the taxes plus the penalty that has to come off of it. So we get all the way out to retirement, and we only have 75% of the $439,000. Now here’s the funny thing about what we have left after tax if taxes don’t increase at all, we would have $329,923 If what we did was just took 75% of that number. Now here’s the funny thing about that. Let’s say we took no tax benefit. By putting money into an IRA, we assume there is zero benefit, we get our deduction, yes. And then we account for what’s the net amount of money we had add in? Well, the net amount each year is this number 4875. You guys are welcome double check my math, I would encourage you to take 75% of this number, foreign and 39,000 our number and you’re gonna get this number, which happens to be the exact same number. If I put in the amount that’s actually mine, of the money I put in 75% of my contribution is mine. Under current tax law, if I’m in a 25% bracket, as long as I wait until 59 and a half to take it out. Well as that money grows, if I only grew the portion of it that belongs to the investor, not the IRS, that’s $4,875 per year, that 400 That $4,875. If I just grew that it’s 7% a year, I have $329,923, the same as 75% of the total growth of my IRA. So if taxes stay the same, all the IRA did was give me tax deferral on the portion of my income I could have invested anyway. Meaning at least there were no taxes every single year on the money. But then this is where the catch happens. What if when you retire Tax rates are 35%? If tax rates are 35% that means we take a bigger number off of the $439,000. So instead of having 329,000 more done, it’s going to be more like $290,000 that 290,000 is a big difference from the 330 And now we’re not even talking about the fact we have money already in IRAs, some old money that’s growing, etc. All of that creates this enormous tax liability starting when we retire and never ending until all the money is emptied out of the account, not to mention that IRAs and before tax 401, K’s can be some of the least effective assets to leave our heirs. So we take a risk that if let’s say the spending on foreign wars, Medicare, Social Security, other social welfare programs, dealing with the nest, next national emergency, whatever that’s going to be, all of those things, if those put pressure on the federal government have to raise taxes, all of these accounts that have never been taxed are going to be some of the most attractive ones out there to tax. And effectively what it will be like if you do the math is like you got a lower rate of return during your entire career. Because the IRS changed rules on the back end, or you were too financially successful, you had too good of a life growing your money, and therefore you’re left with fewer funds after tax inside of your IRA because you were successful. And your strategy actually gave more money to the IRS than if you would have paid them along the way. So that’s the basics of your traditional IRA. There are also some rules on it that you have to start taking required minimum distributions at age 73.

Now with the latest tax act, to say there are a lot of rules around it. And there’s no true tax benefit other than the deferral because eventually, they’re going to tax all of our money. And we’ve made the irrevocable choice to also not just delay the tax, but delay the calculation of the tax, which leaves us vulnerable to tax code changes, that could further hamper our ability to access this money later on. All right, that’s a traditional IRA, Roth IRA. Now let’s look at the same thing. Now with the Roth IRA, we’re able to add $6,500 a year. And unlike the traditional IRA, this money is all ours. Now, of course, you can still get penalized if you take distributions early above and beyond your principal. There are some better access rules to Roth IRAs, you can actually reach in and take principal if you needed it, as long as the account has been open for five years, etc. There are some definite advantages. But now let’s just look at the outcome. I put $6,500 a year in, and I have an outcome of $439,000, the same as the IRA. But the reason it’s so much more after-tax is there are no taxes on the Roth IRA, the Roth IRA is going to give you 100% use of that capital to be able to deploy on your balance sheet the way that you would wish. And instead of having to sort of share, I think of it like elbow space in an airplane, where you’re wanting that elbow rest, but you’re somebody next year kind of have to share it with. With an IRA, we are sharing the elbowroom of the total contribution amount with the IRS. Meaning that if we’re in a 25% bracket and we add that money, we are effectively putting in $4,800 of our money. And the rest is being added by the IRS by not taxing the money. Instead, this $6,500 is all of ours. No required minimum distributions easier access to capital if we needed it early. And the only disadvantage was I didn’t get a tax deduction. And let me frame this up for you. I didn’t get a tax deduction. while I’m working. While I have children living at home and a mortgage interest payment, I lose the deduction. But when I don’t have to pay the taxes is when I don’t have a job when I’m financially independent and retired. That is the huge benefit of getting as much money as we can in Roth Now many of you watching this has spent years putting money into 401 K’s IRAs and other tax-deferred accounts. i It’s not that I would say oh cash out all your IRAs go 100% Roth right now. But it does speak to the benefit of making sure that we have money in multiple buckets on our balance sheet with different types of taxation the same way you diversify investments, we need to diversify the taxation of our investments. So by having something that’s taxable, like regular gets taxed every year could be a rental property could be an investment account, but it’s just only in your name or in your trust, but it’s not in a retirement account. Then we have retirement accounts that are tax, deferred 401 K’s Ira certain types of annuities, those sitting in the tax-deferred component we have to pay taxes on all parts of that money, and we pull it out. And then we have our tax-free component that’s things like Roth IRAs, cash values of whole life insurance, etc. that fit in the tax-free bucket by having those three buckets to pull out of retirement we can actually time our distributions to take better care of our overall financial stewardship. Pay the appropriate amount and fair amounts to the IRS, but not lock ourselves in doing all IRAs in all traditional 401k our entire life so that when we take withdrawals, we’re taking them out 100% taxable, that’s what we want to avoid. So that’s the difference between an IRA and a Roth. In our next episode, we are going to get to the way that you do a backdoor Roth. So with the Roth IRA after is a household if you’re a married couple making 218,000. I think it’s something like 135,000 for an individual. You cannot put money directly into a Roth. Hence why our next episode on how to do a backdoor Roth will be so helpful. We hope that this episode has been a contribution to you being able to design and build a good life

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