Animal Spirits Podcast - Should I Use a Roth or a Traditional IRA?

Episode Date: January 11, 2021

On today's show, we talk with Bill Sweet about the different options investors should consider when thinking about what type of vehicle they should use for their retirement money.    Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits is presented by Liftoff. Liftoff is an automated investment advisory service that is a wholly owned entity of Ridthalt's Wealth Management LLC and is powered by Betterment. Visit liftoffinvest.com for more information. Michael Battnick and Ben Carlson were for Ritholt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinion and do not reflect the opinion of Ritholt's wealth management. Ritholt's wealth management is an SEC registered investment advisor who receives fees

from clients who invest in their liftoff proprietary portfolios. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rittles' wealth management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Battenick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Rit Holtz wealth management.

All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. Today we are here with our CFO Bill Sweet, who is our go-to for all things tax-related. We talked a couple weeks ago on a podcast about a Roth versus traditional IRA and some very, strong adherence on this one. This is almost like wading into the individual versus bond ETF or bond fund, right? Like, there's extreme opinion. So we wanted to, we got a ton of questions on this. So we want to go through some questions with Bill because he knows what he's talking about more

than we do on this stuff. I hope so. Bill's my financial planner. I've got your back. Let's do it. Bill is who I go to for all my questions too. First of all, I want to say, I just want to give my general rule of thumb on this. I prefer to use the traditional tax break when I'm young, because I feel like a tax break will be more important to me when I'm young than when I'm older because I'll have more assets when I'm older. That's my rule of thumb, obviously, with some exclusions here and there. What do you think about that? I would take the exact opposite. I would say that I get the tax break point, but here's the thing. When you're young, when you're in your early career years, that's typically when your earnings are the lowest and you have the longest time to

compound versus the end of your career. Typically, your earnings are higher. Obviously, depends a lot of your career, but you have the smallest amount to compound. And so I think I I take the opposite tack, understanding your point. Oh, wait, whoa, whoa, whoa, whoa, whoa, doesn't it matter how much you earn? My point was that like you could use the money more now than you could then. Yeah, understanding it. And so if you had four perfect pieces of information, meaning income today, tax rate today, and then income and distribution, whenever that is, that can be at age 60, that could be at age 90 and the tax rate there, you could make these decisions with perfection. I think the smarter point is to start at the end and work your way backwards.

And so this all or none thing is a bit of a misnomer. I don't think that in any point you need to say, I only have to can do Roth or traditional and be an acolyte. You don't have to root for the Red Sox or the Yankees. You can do both. And that's where you want to land the ship. So my thought is if you're in retirement, where do you want to be? You want to have X amount of traditional, X amount of Roth. I don't think it matters how much necessarily now. But I think the right thought is when is the smartest time, when is the most tax-efficient time to fund each of those strategies. I think a lot of that does depend on the individual, though, which is why you get Hatfields McCoys in it. And to be honest, personally, I did diversify the tech exposure a little bit. That was kind of

where I fell as I just diversified it. So we've got 10 questions that we're going to get to, but before we do, I have a question of my own. Bill, we talk about like the setting up a traditional IRA doing the Roth conversion. If it's so easy to get in through the back door, why don't they just eliminate the income limits? Yeah, it's a great question. At some point, it was not exactly blessed off. I mean, even the income limit itself is relatively recent in that this conversion, used to be a bit of a misnomer. I would dance around giving that advice to people saying, well, you can, but we're not exactly sure. But only recently, I think in the last three or four tax years, has that been blessed off on by the IRS. The answer is Congress controls a tax code.

And if you've been watching anything in American politics here in the last five or 10 or maybe even 20 years, it's very difficult to get a room of senators or congresspeople to agree on just about anything. And it's just one of these things that's in the tax code that's a loophole. It's perfectly legal and it's exploited all the time. And I don't necessarily think it's problematic because most of the time people are saving for retirement, which I think is in their best interest. All right. So we've got 10 questions. You think we could keep each answer to two minutes? You got it. All right. First, on a recent podcast, you referenced a study completed by Boston College, which points to the fact that 80% of people in retirement have effective tax rates

around zero. And therefore, it makes more sense to invest in the majority, if not all of your retirement egg in the pre-tax bucket. In general, do you agree with this premise? Everyone's situation is a bit different, but there are advantages to the Roth that that article did not reference. Also, a lot of the tax breaks you realize during the working years, salt where applicable, other miscellaneous deductions aren't typically realized in retirement years. Do you have a rule of thumb you could share, or could you share some insight at a high level of how you approach retirement planning? Yeah, I think, again, that rule of thumb I mentioned before is, in my view, the right thing to do. If you can perfectly predict that your income is going to be low enough in retirement that

you're going to be at an effective tax rate close to zero, absolutely. It would make sense to save as much as you can now in traditional, meaning that you're going to distribute those assets in retirement at a zero tax bracket. In today's dollars, you jump above 12%, which I would think is right around low, around $100,000 for a couple. So that's, you know, $20,000 of Social Security, meaning $50,000, $60,000 of distributions or pensions. So I think they're right. I think for the vast majority of taxpayers that are going to be below that threshold, it would make sense to front load your traditional. That doesn't even include things like state taxes, where let's say in New York, you get a $20,000 exclusion per year from all state income tax. And so that would

definitely favor a taxpayer that wants to be in New York. I think in general, that's it. But you also have to factor in that the majority of the country was relatively low savings to begin with. And so I think, yes, for somebody that expects to have a relatively low income, that rule of thumb does play out. Here's another one. One reason I've always thought it was better to use a Roth IRA and Roth 4-1K, is the accounts being tax-free after they've had all that time to compound. In my 20s, I've always maxed out my IRA and recently started maxed up my 401k and let I'm 30. It feels no matter the tax policy or my financial situation or I retire the amount of time that the money has to compound means I'll have huge amounts to withdrawal. I always thought withdrawals were taxed

as income and therefore I want to take out, say, 100K per year. I'd rather do so with zero tax risk. Is that the case to use a Roth? Yeah, this listener speak in my language, he's preaching to the choir for me. I think he hits on a key behavioral hack. Let me ask you guys a question. If you could choose today just to be gifted, a $100,000 market value, traditional or Roth, which one do you choose? Roth. Right, because there's no tax liability there. So why not do that to your future self. A Harvard Business Review article in 2015 found that from 2006 to 2010, the majority of employers that rolled out a Roth 401k for people that switched over, they saved at exactly the same rate in the Roth 401k as they did previously in the traditional 401k. And if you're going to

save at the same rate, in my view, it makes sense to do that in a Roth because after you've contributed, after the contributions done, you have a bigger purchasing power and there's no tax liability associated with that Roth area, allowing it to compound, compound, compound. That's the decision I've made in my personal life. I don't know what I'm going to transition maybe 40, 45 somewhere in that neighborhood. But I'm thinking around when I jump up to 32% tax bracket, that's going to make that switch. And I think the tax period's got it right. So you're going to switch from a Roth to a traditional at that point. Yeah, or tilt the average. Again, I don't think it needs to be all or none, but basically every dollar that I have personally, and I just turned 41,

and it hurts me to think about that, but is in a Roth or Roth foreign care and I rate today. And I've made that, I practice what I preach. I think that's the right thing for me to do. But I'm getting at the precipice where I'm starting to think, geez, in the next five years or so, I'm going to need to flip that switch. I speak with, this was a good one. I speak with experience that you are 100% wrong on Roth IRAs. Oh, thanks.

All right. The power of compound. By the way, I don't even think there was a hay like your show. I think that's, that was the lead. The power of compounding works for both pipes, but tax-free withdrawals far outweigh the possible tax benefits. then there's a lot of quotes in here. The possible, quote, possible tax benefits you, quote, might have when you are retired and drawing on the balance. Consider what the results are if you do super well performance-wise in just a few of the later years, of the 40 years you are contributing. Your whole argument goes out the window. By the way, this isn't our argument. We were presenting the result of a study. My gosh. Your whole argument goes out the window when drawing 4% puts you in the 24% tax bracket. The only way pre-tax contributions work is if you are planning on being unemployed for a few years and do controlled IRA through Roth conversions. Bill, are we 100% wrong?

Yeah, it's the exact opposite point that the first question made, right, is that if 80% your effective tax rate is zero, this taxpayer is positing that, hey, I'm going to be in the 24% tax bracket if I'm withdrawing 4%. Good for him. Yeah, exactly. And so he's in one of the 20% that it probably would make sense to favor of Roth, the compounding effects and everything else. However, he hits on a really interesting point that I want to highlight here. And this is Michael Kitz's idea. I think it makes a lot of sense. He argues that funding your traditional is always the way to go. And the reason is you can, it's not a one way street. You can always do a Roth conversion from Roth 4MK traditional IRA. You can convert that to Roth in any year. The reason that you wouldn't do that or decide not to do that is

taxes. You'd have to eat the tax on any conversion. But let's say at December of each year, you calculate your family income. You're at $90,000, let's say, of gross income. You have about $10,000 of room at the 12% tax bracket to fill that up. And so, So in a lot of ways that for a taxpayer that can perfectly control their income, that makes a lot of sense, that strategic conversion through time or do it at the end, do it in those years in between when you've retired and before you've filed for Social Security benefits, as a taxpayer indicates, your income is going to be low. That's when it makes sense to fill up those low tax brackets. By the way, I know this is so important, but the tax stuff always puts me to sleep.

Don't you think for people that are like arguing about this stuff, Ben made this point that they've already won? Yeah. They're already better off than 99% of people. I'm hearing that 20% that this is a game now. And it's a game worth playing because I think these things do matter, but they matter on the margins. I mean, what are you going to get an extra 2 to 3 to 4% purchasing power of your lifetime? The point is if you've been able to save over time, if you've been able to build up an account balance where these questions matter, exactly to build up an account, Michael, you've won the game. I think this is a softball for you. How should I think about the following two things related to Roth? Tax rates increase a lot, especially for retirees with $250,000 more in annual income and the value of not having to take RMDs from Roth accounts versus non-roth IRAs, it seems like having some diversification in retirement savings accounts is a good idea. Yep, different buckets and fill them up. And again, look at the values. We're talking about $250,000 of household income, right? So again, these are folks in the top 10, top 5%. But that said, yeah, I would agree. My bias is we're living in artificially low income tax land. I think we've been really since the Bush era tax cuts in the early 2000s. Ah, a tax truther. Yeah, well, if we're going to

look at anything going on at the federal deficit or budget, I think it's likely to predict that'll happen. you don't have to introduce single-payer health care to predict that we could potentially have a higher income tax rate in the future. And so if that's your bias and I share it, then locking in a tax rate today does make a lot of sense. Next question. I'm a 23-year-old FAA with, I won't say who. I gear 90% of my clients, especially young ones to Roth strategies. My own savings is all Roth as well. The millions of dollars of compound interest you can receive that will never be taxed by your or your beneficiary seem to outweigh a small tax liability today. Also, never heard of Roth being counted against your FAFSA. Also, my retired clients' lives

would be much simpler and easier with Roth savings instead of traditional. You wouldn't have to worry about Social Security taxes with two-eye withdrawal, clients taking a lump sum for large purchases that will be heavily tax and beneficiary inheriting a large tax liability who are most likely in their highest earning years and already in a high tax bracket. Bill, your thoughts. Yeah, I think they're right. It does make things simpler. There's no argument there that ultimately if most or the majority of your assets are in Roth, you don't have to calculate the tax benefits. He mentions FASA for financial aid. I'll mention another one. Medicare premiums, once you hit 65, if your adjusted gross income is above $178,000 in one year, which is possible if you need to take

R&Ds or let's say you want to do a family vacation, buy a house. If all of your assets are in traditional IRAs or 401ks, you've got to eat that tax and you've got to eat all in one year. And what Medicare does is if you cross certain thresholds, they send you a letter saying, hey, your Medicare premiums out $50 a month. It's $200 a month. And believe me, when you're a client or taxpayer getting that letter, you don't ever want to. get that letter. So I think that's a great, great point. And just to circle back before, like, we don't have to predict the tax rates are going to increase. In 2025, the TCGA expires. And we know at that point, roughly 3% of additional income tax will be added to just about any taxpayer. So I agree with

this advisor. I think generally that's the right thing to do, especially while you're young. All right. This person says, I'm starting to think I should definitely do a traditional IRA. However, according to the IRS website, if one already has a retirement plan through their employer and AGIs above certain limits, the deduction cannot be taken for a traditional IRA contribution. A lot of listeners probably fall into this category as the AGI limit is not all that high, 125K for married filing jointly or 76 for single filers. So yeah, what's the point at where you, it doesn't make sense and you're not getting a break? Yeah, right around there. And again, a lot of our clients, the folks that we work with are here. And that exactly, if you make a traditional IRA contribution, which you can still make just at any

income per year at $6,000 a year, you're not able to take a tax deduction if your income is above roughly $125,000 joint. In my view, that more or less moots the point of contributing to a traditional IRA. It's not that you don't get that basis back. You do, but you don't get it back until you go into the distribution phase and you only get it back pro rata. So if only 10% of your account is basis because you own other 401ks and other assets, you're not able to like pull out that money tax free at any point. So I think for this taxpayer, and this is basically any taxpayer of joint up to about $208,000 of AGI, you are able to contribute to a Roth directly. You don't a tax deduction up front, but again, you get this favorable tax treatment on the back end. Money comes

out tax-free, and it's FIFO. First in, first out. You can pull your basis out at any time if you get into trouble. I am 24 years old, and I've been listening to you guys since December 2019. In episode of 184, Michael was discussing how people in retirement play close to 0% taxes and the discrepancies between the amount invested in traditional 401K and Roth. In the summer, I rolled over a traditional 401k to a Roth. The reason why I did this is because with the stimulus that we had in March and now, this next round, history shows that there will be an increase in taxes. Granted, I'm a long way from retirement age, but the point still stands that I don't know what the effect of tax rate will be in the future. So wouldn't it be better to move into a Roth

have a taxed and not be penalized on the withdrawal? I start a new job in January, so I'll have another 401k, but I'm just more curious about both of your opinions. Yeah, again, I generally feel that that's the right angle for them to take and that if you're predicting future income tax increases, is it would make sense to fill up those little tax advocates today because effectively you've locked in the low tax rate, you don't have to worry about the future. So that makes a lot of sense to me. All right. I think we kind of covered this, but here's another one. Last one. With a traditional IRA, aren't you taxed at the amount you're withdrawing at the time, which includes all of your gains while the Roth, when you withdraw from account, it's all tax free since contributions are

taxed. Yep. Same idea. If you expect that your retirement tax rate is going to be significantly lower, you usually want to favor traditional. Though again, it doesn't have to be all or none. I would pause it, start at the end, figure out when's the right time. time to fund each type of account. What if you stuff your account and just short Tesla and then you don't have to worry about any gains in the traditional IRA? It's a great, it's a great strategy from a tax perspective, I guess, because you've just nuked a lot of economic value. There you go. I tell clients this, the best way to save on taxes is lose money and we're not in that game. And it's also true. Like how many, because we show here in this article that I think it's like

nine to one in terms of assets in a traditional versus a Roth. Yeah. I mean, how many employers even offer a Roth option for 401K? So most people are probably diverse of it anyway. If you have a traditional 401k at work, then it probably makes sense to do an offset with a Roth IRA outside of it if you're not above those income limits, right? I think that makes a lot of sense. The other factor is if you are contributing to a Roth 401k and you're getting a match, that employer match is pre-tax. You're not able to rothify that matching contribution. Why is that? Because you haven't earned it. It's not considered earned income for the purposes of the tax code. It actually is this really wonky thing where I don't believe it's Social Security taxable either,

although I'll go back and check on that. And so it's just a, quirk in the tax code. And effectively, yeah, because you haven't, that doesn't show up anyone in your W-2. That comes up pre-tax. The employer's able to deduct it. You don't get the benefit of a Roth for that asset. Bill, this was wonderful. I learned a lot. I hope our listeners did too. I got smoked right off the bat. I said my real film is traditional and Bill smoked me right off the bat. Well, not for those 80% of taxpayers. I'm the big loser here. No, I think you're the people's. You're the people's advisor, eight out of ten. So good for you. All right, Thank you.

Thanks, man.