IRAs/401(k)s - Financial Alphabet Soup and You
Just after the recent Money Matters newsletter came out, I was speaking with a group of employees at a client company and I asked them if they understood the difference between a Roth and a Traditional Retirement Account. Only one of the group could say what the differences were and more importantly why those differences mattered to her and her family.
In plain English, here is what you need to know about how Traditional and Roth Retirement Accounts compare and contrast. More importantly, you’ll know why this is vitally important for you to understand in terms of the impact on your long term financial goals.
(Note: There are differences between IRAs and 401(k)s, but this topic applies to both.)
Traditional Retirement Accounts
How we save money for retirement matters. The investment tools we select impact the “t” word: taxes. Forget the alphabet soup for a minute and let’s look at an example. Let’s say you could take money from your wages before taxes are taken out and put those untaxed dollars away in an investment account. All of a sudden your taxable wages are less and therefore your income tax obligation is less. Are you following me so far?
Now, you have taken these pre-tax dollars out of your wages so that you can invest and grow your money. When the future rolls around and you retire and you begin taking money out of the account, you will pay taxes on the withdrawal. The myth is that deferring tax on that money will benefit you - it might, and it might not.
Roth Retirement Accounts
What if things were reversed and you paid taxes on your income now and invested post-tax income dollars into an investment account? The bottom line is that you will pay less tax when you retire. Why? Because in this savings model, you can withdraw money from your retirement account completely tax-free.
The reality is that in most cases you will pay less tax starting at 59 ½ years old on funds you withdraw to support your retirement.
Note that the IRS currently allows anyone to convert any amount from a traditional IRA to a Roth IRA.
Of course, under both models your money doesn’t grow unless you continue to contribute to the plan, take advantage of matching contributions your employer may offer (for company plans), and invest wisely.
I’m sure a few questions have come to mind.
Can tax rates decrease negating the value of the Roth IRA?
Sure, tax rates could go down, but I want my clients to have some insulation from rising tax rates. While none of us can predict the future, consider this: “What do you think will happen to tax rates in the future?” 80% of those I ask estimate it will go higher. Even if rates don’t end up going up, clients still benefit from removing this uncertainty from their portfolios and the confidence this provides.
Should I not consider a Traditional IRA?
We treat you as the individual you are so I would be remiss if I made a blanket statement. With that said, let’s go back to basics. In traditional IRA’s, your contributions grow tax-deferred until retirement. When you begin distributions, that amount is subject to income tax.Since no one knows the future, and without specific analysis on your situation, it’s fair to say that diversification of your tax structures, similar to diversification of your investments, is generally a smart thing to do. You avoid “putting all your eggs in 1 basket.”
Does my employer’s matching impact my tax situation when I withdraw at retirement?
Many employers do offer to match a portion of the money you put into your 401(k), which similarly, along with gains, will be taxed when withdrawn. This is because even if an employer matches a Roth 401(k), the IRS requires any match be held in a pre-tax account. The IRS doesn’t control how much of a matching contribution an employer can offer. However, there is a limit to the total amount of contributions that can be made by employers and employees. “For tax year 2022, this total limit is $61,000, up from $58,000. For workers 50 and older, the total limit rises to $67,500 for tax year 2022, up from $64,500 in 2021.”
I’m going to be in a lower tax bracket when I retire, won’t I? Doesn’t it make sense to defer taxes using a traditional IRA?
As with many things in life, the answer is, “It depends.” However, consider that if we plan well, our goal would be that you are NOT in a lower tax bracket. A couple retiring at 65 can expect retirement to be roughly 30 years. You live a good life now and want to continue that when you retire. That will take a lot of money. And if all your savings is in traditional IRAs, it will all be taxed when you withdraw to support your lifestyle. And as already mentioned, tax rates could rise. Furthermore people tend to lose tax deductions as they age - the kids grow up, the mortgage is paid off. The truth is to answer this question for you, a careful analysis must be done.
I know I can convert from my traditional IRA to a Roth, but how do I deal with paying that tax now?
That’s a fundamental challenge of the conversion strategy and needs to be analyzed case by case. Let me share this to help you understand the potential. In projections I’ve done, for example, I’ve found that a client that ended up at end of life with $2,000,000 in traditional IRAs, if they employed a conversion strategy, could end up with the same total account balances, but now with $1,000,000 in traditional IRAs and $1,000,000 in Roth IRAs. Although the pretax account balances are the same, if the effective tax rate is 25%, employing the conversion strategy would net the client (or their heirs) $250,000. This highlights the importance of doing the analysis, and the sooner the better.
In the next blog, we will discuss Tax Changes and Key Amounts for the 2022 Tax Year.
At Aha! Financial, clients receive a personal, customized plan for managing their finances and preparing for a secure future. Don Gottfried, CEO and Founder, considers his clients’ real-life circumstances and creates a strategy that allows them to care for their businesses, themselves, and those they love.