Hi Everyone, and welcome to the Wiser Financial Advisor show with Josh Nelson, where we get real, we get honest, and we get clear about the financial world and your money. This is Josh Nelson, Certified Financial Planner and founder and CEO of Keystone Financial Services. Let the financial fun begin!
Jeremy: Welcome to the Wiser Financial Advisor. Your hosts for today are myself, Jeremy Bush, and Jen Walenter. Our topic for today is Roth versus Traditional IRAs and which account makes better sense for you to use.
Jen: It’s a question we get all the time. Roth or Traditional, benefits, pros, cons, all the things.
Jeremy: I’m going to ask you, since you’re the new up and coming CFP (Certified Financial Planner), Jen, what have you learned? Is one better than the other?
Jen: Putting me on the spot here. I like it. What it really comes down to is your individual situation. What is a Traditional versus what is a Roth? A Traditional IRA is pre-tax dollars going into an account. They are not taxable on the front end, but they will be taxable on the back end. So anytime you take those funds out, taxes will need to be taken out versus a Roth IRA is made with after-tax dollars, which means taxes are taken out in the front and not taken out in the back, so they can grow tax free.
Jeremy: There are a lot of factors to take into account when we’re talking about Traditional versus Roth. What makes sense? What’s your income level? What are your tax levels? So there are pros and cons to both, and they both can serve a purpose in anybody’s portfolio. One of the first things we think about is current versus future tax rates. Now, obviously we don’t have a crystal ball that works, and so we don’t know what future tax rates are going to look like. But since tax rates are at their lowest point that we have seen in quite a long time, it does beg the question, are future tax rates going to be higher? Again, crystal ball’s broken, right? But logic assumes that, yeah, more than likely we’re going to be in different tax brackets in the future, which will most likely be higher at that point.
Jen: Which plays into, if we’re going to do a Roth versus Traditional, looking at that long-term planning, a Roth being after-tax money and we’re going to pull out those funds eventually, there’s something to be said for starting with that kind of an account. But are there limits? Can just anybody start a Roth?
Jeremy: There are income limits. There are phase-out ranges the IRS has created for what you can do, which affects both Traditional and Roth IRAs. The things that aren’t affected by the IRS phase-outs are if these accounts are available inside of your employer plans. We’ll get to that in a minute. But Jen, what are the income phase-out ranges for IRAs, Traditional versus Roth, and when are you not able to contribute anymore?
Jen: Well, if you are going to contribute to a Traditional IRA and you don’t plan on deducting it on your taxes, there are no income limits. But if you do want to go ahead and make a contribution and have it potentially be deductible, some of the caveats are if you are covered by an employer plan. If you are, the limits are broken down between if you are filing joint, single, head of household, or married filing separately. So for example, if you are filing joint, the income limit is up to $129, 000 to $149,000. A single or head of household is $81,000 to $91,000. Married filing separately is pretty low, unfortunately. It’s 0 to $10,000. So, there are limits tied to you being able to potentially have that as a deductible on your taxes. For a Roth IRA. income limits are quite a bit higher, but they are still limited. If you are filing joint, it’s $242,000 to $252,000. Single and head of household is $153,000 to $268,000, married filing separately, up to $10,000.
Jeremy: Let’s unpack that for our audience. For instance, for a Traditional deductible IRA contribution, if you are married filing jointly, Jen gave the range of $129,000 to $149,000. What that means is that you can contribute the maximum amount if you make under $129,000. Between 129,000 and 149,000 is what they consider the phase-out range, so you can’t contribute the max, but you still might be able to contribute some dollars to that, and take advantage of the tax deductible feature. If you make over that $149,000 married filing jointly, then you cannot contribute at all and get the deduction. Same principle applies to the Roth limits. You can contribute if you’re under the phase-out range. In the phase-out range, you can only partially contribute. Above it, you can’t contribute at all.
So, why are there two different IRAs? What’s the benefit of having a couple of them, like a Roth and a Traditional? It comes down to what we call tax diversification. Tax diversification is to prepare for when you’re living in retirement and all of a sudden the AC goes out and you need to spend $10,000 to $15,000 to replace it. Ouch, big bill. If all of your money is sitting in a Traditional IRA, then that’s the only place you can take it from. If you have money in an IRA and a Roth and a brokerage, that gives you what we call tax diversification. You have multiple pots of money that you can go to, and where you take money out affects your taxes, right? Say you’re living in retirement and you’re taking a certain amount of money, let’s say you get social security, you have a pension, but you’re also supplementing with IRA funds or Roth funds or something like that, and you’re trying to stay under a certain tax bracket. Or let’s say you’re on Medicare and you’re trying to stay in a specific IRMAA (Income-Related Monthly Adjustment Amount) bracket for Medicare. If you’re forced to go to the Traditional IRA and take those funds out for that emergency expense, that might push you into that next IRMAA bracket or that next tax bracket.
Jen: Because those funds that you pull out are going to be added to your income.
Jeremy: Yeah, if it’s from a Traditional IRA, whereas if it’s from a Roth, it isn’t. So they both serve purposes, but having that tax diversification is a very great thing. Now, we talked about income levels. The one place that income levels do not come into play is within employer plans. Typically the way employer plans have been set up over time is when you contribute to your work plan, your 401K, your 401A, 403B, whatever you call it, whatever industry you’re in, typically your contributions would be pre-tax contributions. So they would go into that Traditional pot. Almost always, the employer contributions, the employer match is also pre-tax. Not 100% of the time, and rules continuously change on this, right? But usually that is the case. Now for most plans in the modern day, an employee can also elect to do Roth or Traditional or both. You can split that. If you’re contributing pre-tax, you get a tax deduction in the current year that you’re doing it. If you’re a high-income earner, you’re not going to get a lot of tax deductions. They’re few and far between based on your income. They phased out pretty quick. 401K contributions tend to be one of those last remaining things that you can still get a tax deduction on.
Maybe taxes aren’t a big issue for somebody who’s starting out. We talk with young people a lot who are doing this. And that’s the first question out of my mouth: “What kind of tax situation are you in? Do you need the deductions?” And most of them are like, “No, I really don’t.” So then, “Well, let’s take advantage of this Roth. The longer it’s in there, all those earnings are building up tax free.” You’re going to have a huge tax-free pot of money someday, right? So all of this really plays in when it comes down to it, but there is no universal answer. Like you said at the beginning, it depends on your personal situation. And that’s just doing the contributions and things while you’re working. So, how often do we talk to clients about Roth conversions?
Jen: All the time. Frequently throughout the year. It is a common hot topic.
Jeremy: So even if you’ve been paying into your 401K in that pre-tax category because you’ve been a high earner all your life or you didn’t know that you need to take advantage of those Roth contributions, and now you have that one pot of pre-tax money, you’re not necessarily stuck with that. You can do Roth conversions basically forever. It gets a little harder when you reach RMD (Required Minimum Distribution) age because that limits things a little more. But at the same time, you can just elect to take chunks out of that Traditional pot and move it over to Roth. There are tax implications with that in the year that you do it, so that’s another conversation entirely. But in effect, it does give you that tax diversification that we’re talking about. There are a lot of rules around that, but that’s what we’re here for is to help you out when it comes to that stuff. Over all, current and future tax rates, income level, whether that’s an available option inside of your employer plan, all play into it, right? So we talked about the contribution limits. Inside of a work plan, the maximum amount that you can put into a Traditional or a Roth IRA have much bigger limits. Sometimes in an employer plan you can still contribute to a Roth and do a lot more inside of there. Sometimes that’s the best place to start building up those Roth funds, whether you’re already in the habit of contributing or you’re brand new to it. There are fantastic options available to you, but things to consider. What is your income level? Are you in that phase-out range? Does your employer offer IRAs inside of their employer plan? These are all things that CFP professionals can assist with. We know the right questions to ask and we can help guide clients on that tax situation. With the right information, we can really dial in and say, “This is what we recommend. This is what we think you should do and how it may benefit you in the long run.”
Jen: And having those conversations quite frequently, we do encourage everyone to look into what are the options in your employer? We encourage a lot of that conversation. And so if it’s something you have questions on, feel free to contact us here at Keystone and we’d be happy to help.
Jeremy: Yep, no charge for those initial visits. If anybody does have any questions, current client or not a client at all, we always like to meet with people and make sure you’re on the right path with all that stuff. Hopefully this brought you more information about the intricacies of Traditional and Roth, although it’s not a fully comprehensive view at a very high level. There are other rules and things that go along with this, but these are options that everybody has. And you can’t underestimate tax diversification. The earlier you can get at that, the more options you have and the easier it is to do. But if you’ve been doing it your whole life as that pre-tax stuff, it doesn’t necessarily mean that you’re stuck. There’s always something you can do. It’s just going to look a little different, but that’s where we can help guide you and give you the right ideas on what makes sense and when and how it works.
Well, thank you all for joining us today. This has been the Wiser Financial Advisor Podcast with Jeremy and Jen. If anybody has any questions, feel free to check out our website, www.keystonefinancial.com . Give us a call at 970-744-5408. And if you’re listening to the podcast, go ahead and hit subscribe on your favorite podcast service. We’re always happy to bring you some good content and hopefully some entertaining conversations.
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