In this show, Mike and Amy discuss the basics of Traditional versus Roth Retirement Accounts, how they are different, and when you should consider using each.

Mike and Amy cover:

The Basics – Traditional Retirement Accounts (03:04)

The Basics – Roth Retirement Accounts (04:48)

Required Minimum Distributions, Withdrawals, and Penalties (06:16)

When To Use Each Type (13:16)

Planning Complexity (21:20)

Wrap Up (23:58)

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TRANSCRIPT

Mike
Today, we’re going to be talking about another one of those great debates in financial planning, and that’s whether you should save in a traditional or a Roth retirement account.

Amy

My answer is everyone’s favorite answer from a financial planner or tax advisor. It Depends.  But this week our. Goal is to help you understand the difference.  And when one might be more appropriate  for your situation.

Mike

Yeah, that’s right. Always, always the standard answer for financial planning. But yeah, today we’ll walk through how the accounts work, differences between the accounts, withdrawal requirements and when you should consider using each of these.

Announcer

Welcome to Operation Retirement Readiness, where Amy and Mike’s two certified financial planners talk about how military members can prepare for transition and how veterans can prepare for ultimate retirement. This podcast represents the views of the hosts and any guests. It is for informational purposes only and should not be considered tax, financial or legal advice. All information is regarded to be from reliable sources. The hosts are not responsible for any losses, damages or liabilities that may arise from the use of this podcast. This podcast is not intended to replace professional advice.

Mike

And then in the intro we mentioned that while it’s often debated and people like to, you know, talk about this like they talk about the Survivor Benefit Plan, we did a few weeks ago. People are passionate about Roth versus traditional and you know it’s not always easy to figure out. So why is that?

Amy

One of the problems is that they’re perfect information. Something.

Mike

Oh, so is that that that’s all you need to consider.

Amy

I’m sure I missed some other things, but yeah, that’s pretty much the long and. The short of it.

Mike (03:04)

All right. So let, let’s start with the basics. Most retirement accounts come in two different options, one being the traditional, the other being a Roth. For example, you could have a Traditional IRA or a Roth IRA could have a traditional 401K or a Roth 401K. And the TSP403-B’s and many of the other retirement accounts that are less common also have these features. So the primary difference really ends up being how those accounts are taxed and when they’re taxed.

Amy

Yeah. So let’s start with the original. So the traditional versions of all of those types of accounts that you mentioned, they, they’re the original, they’re the oldest. The traditional account allows you to take a tax deduction now. So when you make your contribution. You don’t recognize that income in the year in which you make that contribution. There’s some limitations around this. Particularly with respect to the IRAS. But once the money is in. The account so you haven’t paid tax on it. It grows tax deferred. But then you’ll you’ll pay taxes when you make your withdrawals in retirement later on. Now there’s no income limitations to contribute to a Traditional IRA. So I mentioned that there there might be limitations with the Traditional IRA. Anybody can contribute to a Traditional IRA, but there could be income limitations for whether or not you get to actually take tax deduction on your tax return. The maximum IRA contribution for 2024 is $7000. For those under 50 in 8000. For those who are 50 or older.

Mike (04:48)

Yeah. And the the Roth account basically flips this. You use after tax dollars, meaning you don’t get a tax deduction when you make your contribution, but your earnings continue to grow, tax free. And anytime you take a withdrawal subject to some specific rules, you know it’s it’s tax free. So there are income limitations for Roth accounts and like the traditional. If we’re talking on the IRA side, you can contribute 7000 if you’re under 50 or 8000. If you’re over 50. And you know, based on your modified adjusted gross income, which you can find on your tax form. If your income, if you’re single and your income is under 146,000, you qualify to put in the full 7 or $8000 that gradually phases out up to $161,000. And if you’re making more than that as a single person, you’re you don’t qualify. For married filing jointly, the income limit for full contribution is 230,000 and that gradually phases out then 240,000. So the withdrawal age for retirement accounts is generally 59 1/2, although there are a few exceptions. Any other withdrawal rules we should be understanding before we make the decision, Amy?

Amy (06:16)

Yeah, there’s plenty. So one of the big differences in the the traditional retirement accounts that I talked. About.

Is that you know, the idea is you haven’t paid taxes on the money that you put into that account and then it grows tax free. Well, what the government does in order to make sure that you pay taxes on that money before you’re before you die is they have this thing called required minimum distributions or R&D’s. Originally, the rule was that starting in the year in which you turned 70 and. 1/2 actually. April by April first of the year, after you turn 70 1/2, you would have to take your first distribution, so a minimum amount that’s calculated in the tax code for how much you had to take out, why 70 1/2 who only knows but that. The rule in the last couple years we’ve had two versions of secure acts and the R&D ages have started to change for so at this point, if you haven’t started your RMD’s, then you won’t need to start your RMD’s until age 73. If you’re born in 1960 or  age 73, and then those who were born 1960 or later won’t need to take them in RMD until age 75. So. So to clarify, you know, if you’re in the military and you’re just getting ready to retire, you probably were. Born after 1960. Which means you won’t have to take an RMD until age 75.

Mike

And Roth IRA’s have never had RMB’s. And now, thanks to secure 2.0 Congress recently passed, neither do the retirement accounts that you’d have through your workplace if you have a Roth that used to be one of the kind of I don’t know, loopholes if you is, is a strange rule that you had to start taking RB’s. Out of workplace retirement plans, even if they were raw. So a lot of times that would cause people to have to roll over their 401K’s into IRA’s to avoid that. So Congress kind of closed that and said no. If if it’s a Roth account, we’re not going to make you take an RMD, which is a good thing and and may. Allow you to stay in a. Workplace Roth retirement plan if you like it versus having to roll that to an IRA in the future.

Amy

So we talked about when you have to take money out of a Traditional IRA, so you know as you get older, the government wants to collect their taxes on that money. So they make you take it out. On the flip. Side on the front end when can you? Take it out. So after age 59, 1/2 is when you can take out money from your Traditional IRA without. Penalty. Before each 59 1/2 you will have to pay a 10% penalty plus the taxes. If you withdraw the money from your IRA. Now there’s a few exceptions. One, you know one of them is a first time home purchase up to $10,000 for qualified expenses associated with that purchase, medical expenses, if they’re, if the medical expenses exceed 7 1/2% of your adjusted gross income. Education expenses for higher education. Death or disability in certain situations and then military reservists called. To active duty. For at least 179 days, may be able to make a withdrawal without paying the penalty. Now, those withdrawals are still subject to tax. You don’t have to pay the 10% penalty if you meet one of those exceptions.

Mike

One of the unique things about the Roth IRA is that you can always take withdrawal of any contributions you’ve made. At any age, and that’s a, you know, relatively unique feature of retirement accounts probably don’t want to do that. You don’t want to impede the compounding machine that’s working. But if something came up, you you could do that and and get to that money. To withdraw earnings you can do that without a penalty in taxes. If you’re 59 1/2 and the account has been open for at least five years. So if you’re under 59 1/2 and the count is open less than five years, you’ll pay a penalty and taxes on that money. The the earnings, even though if you left it there for longer, you never would pay taxes on.

Speaker

Yeah.

Mike

So the exemptions are the same as Amy just ran through for the Traditional IRA, but you know, just know the difference that with a rough IRA, you can’t withdraw contributions without penalty. So if something comes up, it can make it a. A good savings vehicle, even if you’re not 100% sure you can leave it forever. In that account. You know, maybe you’re going to purchase a home and you know 10 years and you are interested. Then you know using that money you could use your contributions to to make that purchase. Now the workplace plans, they are different and can vary by the individual plan that your employer puts in place. But a couple of points that are specifically. Governed in the tax code are if you take an early withdrawal from a workplace retirement plan for education or to buy a home, those are not covered, so you will pay the 10% penalty on those. But one of the other unique features is. If you end your job after after the age of 55, maybe you’re retiring early. You can withdraw from your 401K without penalty. You have to end that job to be able to do that, but that is one of the features of the workplace retirement plans.

Amy

So I mean, I think because there’s so much complexity here, we just went through, you know, rules for the Traditional IRA rules for the raw IRA. Rules for work release. Retirement plans. They’re all just a little bit different. So the take away from this is if if for whatever reason you’re considering taking money from any sort of retirement account or retirement plan, you really need to do your homework, you need to understand whether or not you’re going to pay a penalty now, how much you’re going to pay in taxes, if anything. But then you also need to pay attention to what an you know, what kind of impact this is going to have on your long term retirement plan. So you need to understand both the short term consequences as well as the long term consequences to your financial plan.

Mike (13:21)

Yeah, that’s a great point. So we discussed the account basics. So let’s let’s talk a little bit about when you consider using them. And the first thing to kind of understand. All else being equal, if we had a flat retirement or flat tax rate across the board, say 20% and everybody paid that on their income, there’d really be no debate over this because it’s you’re either paying the taxes up front and then it grows tax free or. You’re putting it in tax, you know, and getting a tax break up front, but then you’re going to pay them over on the long term on the growth. So the debate really comes in because we’ve got this progressive tax system and your percentage of your taxes goes up as your income increases. So the general idea behind the decision is kind of tax rate arbitrage and trying to. Pay taxes when they’re lower. And defer taxes when they’re higher.

Amy

Exactly. So the idea is to choose to pay your taxes on that money when your tax rate is low, and defer the taxes when your tax rate is. Is higher so that you can pay it when you think that your tax rate will be a little bit lower. So that’s the arbitrage. It gets challenging because there’s there’s a laundry list of reasons on why you’re and you may not know exactly what your tax rates are going to be even just next year or within the next five years. Which means you also may not understand what your tax rate is going to be. Out in your 70s or 80s. You know, we talked about the RMB’s, so if your RMD’s are big, you can actually get pushed into a higher tax bracket without realizing that that’s what’s going to happen. You can’t simply assume that when you retire and now you have your pension and Social Security, you’re simply going to be in a lower tax bracket. That might be true, but it may not be true. Do you have to take? RMD’s. So I know that we’re going to dive into a couple scenarios in our next podcast, really dive deep and talk through all of this, but for this episode, Mike, can you please just frame up a couple of times and couple of examples of how, when, and how you’d use each of these different accounts?

Mike

Sure. Let’s let’s talk about somebody that’s maybe mid career or you know 5-10 years from military retirement and. Spouse isn’t working, so it’s just one one income coming in. They may be in the 15% tax bracket because again, you’re getting the tax breaks of basic allowance for housing and basic allowance for subsistence. Those things you know don’t get counted. So your your income looks pretty low even though. It probably technically isn’t that low, so if if you’re. That camp, you know, a Roth can make sense because the odds are, especially if you’re going to go through military retirement like you just said, when you start looking out and Social Security and a pension. You’ve already got that minimum amount of income coming in. That’s going to put you into a, you know, the lower tax bracket. So then you add on, like you said, the RMB’s, you know that that may be a good idea to stay in the Roth while you’re in the military. And then if you look at specifically the 2nd. The rear. Scenario you’ve made it to military retirement. You’re getting your pension. Maybe your spouse is going. Back to work. And you’re straight in your second career. You could jump, you know at least one and maybe even 2 tax brackets and could be much higher than what you you know, project to be in the retirement. So in that case then it makes sense to kind of shift to the traditional where you’re deferring taxes, hopefully getting the tax break and doing that. And you know, and then in retirement, again, hopefully, hopefully you’re.

Mike

Income tax bracket will drop a little bit and your rate will drop, and then you’re, you know, making those withdrawals. So you know it’s it’s complex, a lot of things like Amy talked about and as as folks like to say, the tax code written in pencil. So the idea that we know what’s what the tax rates are going to be. In. 50-60 years is is a hard you know, a hard problem. But you know you you plan based on what you know and you know if you need to maybe even hedge a little bit maybe put some in rough and and some in traditional but just kind of understanding. Again, when you’re when you’re in a lower tax bracket, that’s when you want to, you know, think about the Roth, and when you’re in a higher tax bracket, that’s when you want to think about traditional and deferring taxes.

Amy

Yeah. And I think, you know, we’ve talked about this just a couple. You know a couple of times, but to expand on it further because you know this is at least half the equation, at least half the equation. Is trying to figure. Out what you think your tax rates are going to be when the money is withdrawn? So you alluded to the fact that Congress can make changes. So obviously that’s completely out of out of your control. We have no idea what Congress will choose to do with taxes. Maybe rates will go up. We’re at historically low tax rates right now. These are the lowest tax rates we’ve seen, I think in all of all of history since we’ve had. And income. If not the lowest, certainly among the lowest, but it also includes, you know, we mentioned, so you have, you’ve got your income, it’s pretty intuitive. Most people are prepared to take into account their. Their Social Security. Maybe you’ve been thinking about the interest and dividends coming off your taxable investments, but? Something else to keep in mind is that once you’re older, if your spouse passes away. Then. Then you’re now in. Now you’re filing tax is single as a single person. So those big withdrawals if if. You. If both of you were saving in your IRA and you sort of expected your tax rate to be married filing jointly. What your spouse passes away? You may be surprised to find yourself in a. Much higher tax bracket. Because you’re having to file at the single rate, but you have the same amount of RMD that’s having. To come out. Because because of the way the tax calculations work. And then something else that people need to keep in mind when secure act came along one of the one of the stipulations is that. When you leave your IRA to. Your. To your beneficiary, whether it’s a child or a family, a different family member or a friend, whomever you leave it to besides your spouse and a couple other qualified. Beneficiaries. Those people have. To take that money out within 10 years. So if that’s traditional. Because the the 10 year rule actually applies to both raw amount money and traditional money. But if it’s traditional money and you’ve left it to say, you know at your children, there’s a very good chance they’re in their peak earning years right when you’ve left them a pot of money that will have to come out in a short period of time. So. Just imagine or assume about 10% per year, so we can have a huge impact on your ability to pass on generational wealth. So it’s it’s a lot, there’s a lot going on and a lot to consider and and that’s that’s half the equation. That’s probably the hardest half to figure out.

Mike (21:20)

Yeah, all this to say, it’s super complex. Like you said, some planners that I heard on podcast talk about, you know you you need to decide how you’re going to do your tax planning. You can either do it two, one or zero, and that means, you know, two people are still alive and and you’re projecting that. For a long life, you can. Do it. Projecting it for you know, one member of the couple still being alive, or you can do zero, which is looking at that the next generation and and how taxes would impact them based on what you’re inheriting and and like you said with the traditional having to take that out now within 10 years and pay taxes on it, so. UM. Again it it’s complex and then if you add in you know conversion strategies, you know we talked about deferring during your post military career when your taxes are high, you know if you retire early before those RMB’s or Social Security kicks in. You may drop down into a pretty low tax bracket, and that’s where maybe you convert from traditional to Roth IRA’s and pay the taxes again because they’re lower, but. Really the only way to know did you make it the best or you know, an optimal decision is well, after you died. And really whoever has inherited the account has used it all. You could go back and say, well, did we did we do OK? I mean you can. You can make some educated guesses, and that’s really what you have to do with any of this is kind of just based on the information we have, the tax rates we know about. Well, you talked about it being historically low. Well, if if Congress doesn’t act in two years, the current rates are going to roll off and we’re going to go back to you know the pre tax cuts and job act numbers. So things will change again, so. And if if somebody’s got. The you know crystal ball and can tell me what if Congress is actually going to do anything this time or if it’s going to, you know, just roll off because of inaction? I’d I’d be interested to know what what is going to happen. But again we don’t. So we just plan on basically what we know today, so. Amy, did we cover the basics of the Roth versus traditional, and now we’re gonna, you know, do at least one more, maybe two more shows to talk about this more in depth. But anything else you you want to hit on?

Amy

No, I I think we have the big points. You know the key takeaways being that the Traditional IRA is in traditional accounts, your 401K, you’re you’re deferring taxes now. So you’re you’re not paying tax on that money now. It’s going to grow tax deferred and then you have you’ll pay taxes when the money is withdrawn and you have to take it out when you’re in your 7. These. The Roth IRA you pay taxes on the money that you’re investing now, but the growth and the withdrawals are tax free later on. And you know, I think we really hit home the fact that the decision on which account to use, which type of account to use is is kind of complex. But the general rule of thumb is use a Roth when you know or are pretty sure your tax rate is lower than your expected tax rate in retirement, and then use on the, you know, the flip side. So a traditional account. And your tax rate is higher than you expect it to be in retirement?

Speaker 2

That.

Amy

So I think that’s, you know, those are the those are the three key key takeaways even if the last one isn’t crystal clear to to everyone right now because we don’t have crystal balls.

Mike

Thanks. And as we said, you know, in the next one, we’re going to dive even deeper and and run through some scenarios on this decision. And so until next time maybe.