Podcast Show Notes & Transcript

So last episode we talked about the differences between Roth and traditional retirement accounts, but today we’re going to go a little bit deeper. Why don’t you tell us how we plan to do that?

00:00:12 Mike

Yeah, you know, so we gave a good overview. If you didn’t listen to it and aren’t familiar with those two types of accounts for retirement savings and suggest you go back and listen to our previous episode. But today we’re going to run through some scenarios just talking about some examples of when you might consider using a Roth versus a traditional.

We’ll also talk about the backdoor Roth. If you make too much money to contribute directly to a Roth account.  And then finally, we’ll look at a couple of scenarios where it might make sense to think about doing conversions from traditional to Roth accounts. If you’re in a lower tax bracket at a certain point in time.

And then stick around to the end, we’re going to, you know, quiz each of us on, you know, whether we would prefer a Roth account or a traditional account.

And probably some caveats with that. But what we think so why don’t we get to it?

00:01:44 Amy

Last week, Mike mentioned, you know, we covered the basics of the different types of Roth and traditional retirement accounts.

So it would be great if you can go back and listen to that episode, but we’ll do a quick recap of Roth versus traditional Mike would why don’t you get us started?

00:02:03 Mike

Here. So basically a Roth account is after tax money meaning.

It comes off its its income you’ve received and you’re going to put it into that account.

With the traditional account it is pre tax money. So let’s say you contribute $5000 into your traditional account for the year.

That would get deducted from any income you have that year. So if you make $100,000.

And you contribute that $5000, you’re only going to pay taxes for that year on $95,000 of income, so generally you.

Use the Roth when your tax rate is lower and the traditional when your tax rate is higher because you want to get that tax.

00:03:01 Amy

Exactly. Now there’s one thing to add with the traditional account, and that is that you can make what they call a non a non deductible contribution to a Traditional IRA.

So you put the money in and you don’t get to deduct it, so there’s not actually a tax advantage up front. Why would you do that? Well, we’ll get into that a little bit later. It’s it’s most often it doesn’t have to be, but most often it’s tied to a strategy that some people call the backdoor Roth strategy, but.

It’s a way to just get extra money put into an account a retirement account. Even if you’re not able to contribute because you make too much money to contribute to a Roth, or you make too much money to be able to deduct the contribution. So we’ll get into that. But let’s first start with some of the easier stuff.

00:03:55 Mike

Yeah, I agree so.  Let’s talk about some of the more straightforward scenarios when you’re just trying to decide do I put money in the Roth, or do I put money in the traditional account? So, Amy, why don’t you kick off with scenario #1?

00:04:12 Amy

Yeah. So let’s say you’re new to the military. So you’re you’re probably young, you’re in your 20s or 30s, you’re at a junior rank, and you’re probably making the least amount of money that you know, you’re definitely making the least amount of money that you’re gonna make.

In your military career. And maybe even the the least amount of money that you’re going to make in your entire lifetime.

This would be the perfect time that you take advantage of Roth contribution, so you’re making less money, you’re in a low tax bracket, and the money has a long time to grow, so it’s sort of a perfect opportunity to use to take advantage of the Roth.

00:04:51 Mike

Exactly. And for scenario #2, let’s look at the flip side. Basically, you’re tired from the military. You’re starting to get your pension, you’ve taken your second career job after retirement and maybe your spouse is working and you’re you’re in your, you know, late 40s, 50s.

Probably your peak earning years, well, that’s at the time when you’re most likely going to benefit by deferring taxes, especially if you’re going to retire, you know, maybe in your mid 60s and have some time where you could do some conversions in the future and so.

Again, we’ll, we’ll talk about the conversion piece in in a little bit, but if you’re if you’re in that high tax bracket.

You know 28 to 30 Plus percent bracket you you definitely want to consider deferring taxes if you if you think your your taxes might be lower in the future when you actually retire.

00:05:54 Amy

Yeah, and. And another time that might happen in your career, in your military career, not just, you know, after you retire, drawing your pension, you have your second career on top of that, another time you might be bumped into a higher bracket is if you if you’re able to take advantage of a bone.

Like continuation pay or maybe a bonus associated with your specialty or something like that, that, that, that bonus may kick you into a much higher bracket than normal. So you might take advantage of making traditional type contributions either to your TSP or to.

And or to a Traditional IRA. Of course, taking advantage of that TSP first, because that’s where your pre tax benefit is going to kick in. If you’re in that higher tax bracket help bring down your taxable income.

00:06:49 Mike

Yeah. And the good thing about this decision is you can change it either.

Each year, I mean, you could even change it, you know, midway through the year depending on, you know which you’re contributing to, whether it’s a workplace or your IRA, you could just decide, hey, I’m. I’m right on the line. I don’t know which is better. I can contribute half of the money.

To the Roth side of the IRA and half of the money to the traditional again, as long as you’re in those income brackets that you need to be. But it’s very.

Possible and allows you to, you know, decide like when there’s there’s life events come up where you know, maybe a big bonus or something or your spouse gets a bonus or starts a new job, it may shift your thinking of of where you should be contributing. And so, so that’s that’s a great.

00:07:48 Amy

Yeah, yeah. I mean it’s it’s nice that you can be so flexible.

So you know the going back to the non deductible contribution into a Traditional IRA. Again, what that means is you’re putting money into this IRA, there’s no tax benefit. It’s sort of like a Roth in that.

But there’s the difference is with the Roth. You know the money grows, tax, tax free, and then you take it out tax free. The difference with the non deductible, non deductible Traditional IRA is that you will pay tax on the money when you take take it out. If there’s been growth. So for example, let’s just pretend like you made a $5000 non deductible.

Contribution to a Traditional IRA, you invest the money in some index fund, and then 30 years later you decide to take some, some or all of the money out.

You’re going to pay tax on that money, except for the $5000 you contributed. So if you take it all out, let’s just pretend like you know, it’s grown to $30,000. You’re going to pay tax on 25,000. So that’s 30 minus the five. Now, why would you do that?

When the Roth would allow you to make that after tax contribution and take the money out tax free.

Make you want to explain that?

00:09:09 Mike

Yeah. So there are, there are income limits for Roth IRA’s. And so that’s the primary reason you you know, everybody can’t just go to a Roth. And so right now if you if your adjusted gross income is over $240,000. Married filing jointly.

You can’t contribute to the raw, so that forces you to contribute to the traditional, which also has the limits on where you can make a deduction for the. And so that pushes people into the non deductible Contribution for for Traditional IRA.

00:09:55 Amy

Exactly. So essentially what we’re saying is that the contribution to the non deductible Traditional IRA is, you know, people talk a lot about this. This thing called a backdoor Roth. That is the first step to being able to convert money from a traditional area to a Roth IRA.

So it’s a conversion, but the contribution to the non deductible IRA is the first step.

But we’re kind of getting a little bit ahead of ourselves. Let’s let’s, let’s talk about when this sort of scenario might might make sense.

00:10:32 Mike

Here. So let’s say you’re recently retired military officer. Your spouse is also working. You’re working your second job.

You’re earning, you know, combined, say, $350,000 a year. Well, you’re you’re definitely over that 240 limit to be able to contribute to the Roth and at that point, if you’re already maxing your workplace. Plans like your 401K.’S.

And you still have more money that you want to continue saving for retirement. If you can’t go into the Roth vehicle directly.  You can contribute. You make that contribution, as Amy said, who a Traditional IRA.  You won’t be able to deduct it from your income tax that year, but it’s now in that Traditional IRA account.

00:11:33 Amy

Exactly. So you know the key to this is making sure that all the record keeping is correct. So if you make that non deductible non deductible contribution, even though there’s not an impact on your taxes today, you’re gonna want to let your tax preparer know about that contribution or document it.

When you prepare your own taxes.

Is it’s documented on something called a form 8606, so your tax preparer is familiar with this or you know that your favorite tax preparation software program will generate this form for you as long as you tell the program about the contribution the form.

8606 is how the IRS knows that you don’t have to pay taxes on that money.

That you’ve already contributed because you didn’t get a tax benefit when you contributed it and and this is really a crucial step because a lot of people missed this step. So they they’re on their way to using this strategy, but they haven’t documented the contributions that they’ve made. And if you don’t go back and fix that, then technically when you withdraw.

Or convert this money. You’re going to have to pay taxes on the full amount, so essentially you will have paid tax on the money you contributed. If you didn’t get a benefit and then you’re gonna pay tax on that money again and nobody wants to be taxed on money twice.

So what happens? You know, sort of we. So we talked about the.1^st step. So then the second step is at some point in the future you decide that it’s you will you would prefer to have this money instead of being in a Traditional IRA, you would prefer to have this money in a Roth IRA. And this is where the conversion comes.  So when you do this conversion, you essentially are getting in touch with the custodian, so the institution holding your money and you tell them you want to convert money from your Traditional IRA directly to a Roth IRA. So when that conversion happens automatically, they’re not going to withhold taxes or anything, but you are going to receive a 1099.

Are so a tax form from your custom?

Put in documenting this conversion and it’s it’s going to say that, you know, let’s pretend it’s $5000, so it’s going to say that you made a distribution of $5000 from that from that Traditional IRA, and it’s not going to say whether or not it’s taxable. If you’ve properly filed the.

Form 8606 I mentioned earlier, then you’re not going to pay tax.

On the amount you contributed. So if you put 5000 in at some point in the future, you decide that it’s you would prefer to have this money in a Roth, you move it to the Roth, you get the distribution because you’ve documented the $5000 already and it’s a $5000 conversion. Then there’s no tax.

00:14:29 Mike

Let’s talk about a few of the details. So the length of time the money has to stay in the Traditional IRA before you make that conversion is is is debated and we suggest you talk to your tax payer or your financial advisor to make sure that you’ve got. They’re they’re kind of blessing on the timing.

There’s also some debate on whether you should actually invest the money while it’s waiting there, or just leave it in cash. So again talk to talk to whomever you’re getting tax advice from, and make sure that you’re you’re following the their their suggest.

But as Amy said, when you make that conversion, you’re you’re only going to pay on the growth of that money. So even if it’s sitting in cash right now, you’re earning a little bit of interest. So there may be, you know, a couple dollars that you have to pay taxes on. But again, the bulk of that will be converted without having to pay money.

00:15:36 Amy

Exactly. And so, you know, even though there’s a debate on the timing, I mean, some people say that you can do it immediately. You know, you put it in one day, you change it the next day. There are people who completely disagree with that. Sometimes it’s months, sometimes they they want. You to wait. The calendar year, you need to talk with your tax advisor and. Make sure that you’re getting good advice for your personal situation, but regardless, you know if if the plan is that at some point you do want it to convert this money to Roth money, it’s generally better if you can convert in the shortest amount of time that your tax advisor is comfortable with you doing that. And like Mike explained, it’s potentially better to just leave that money in cash while you’re waiting to decide whether you’re gonna convert or not. But if you want to invest, then like Mike said, you, you would only pay tax. On the growth? Now the one key point to all of this is, you know we’ve we’ve sort of attacked this. Our scenario has been that you’ve had this one non deductible Traditional IRA, no other IRA money out there and that’s that’s sort of the best case scenario when you’re thinking about how how to do. Roth conversions or or what they call a rack a backdoor Roth. It works best if you don’t have any other traditional IRA’s with money in them, so if you’ve left a job and you’ve rolled your 401K into a Traditional IRA, that money is all pre tax. And the IRS looks at that as Even so this IRA has, let’s call, 100,000 bucks from a a AA401K. It’s all pre tax and then you put $5000 in a non deductible IRA. So now you’ve got 5000, that’s after tax money and 100,000. That’s pre tax. Money. When you decide to do your conversion, the IRS sees that as one bucket of money, so $105,000. So they’re not going to let you just move the 5000 or convert the 5000 to the Roth from the after tax. IRA, they treat it so even if functionally, logistically, the money is literally coming from that, that non deductible IRA. To the Roth IRA. The IRS treats it as if a portion of that Big IRA was actually converted, so that means a large portion of what you converted is actually going to be taxed when you do it. So for that reason, if you’re thinking about using this strategy, you know you don’t want to have a big bucket. Of of pre tax money sitting in an IRA, so it’s best if you talk to your tax preparer or a financial planner just to make sure you understand what the impact would be. It’s not that you can’t do rough conversions, but you certainly want to understand what the taxing cut impact could be. So, Mike, let’s, let’s keep going with different kinds of conversions and scenarios beyond what we’ve just talked about.

00:18:48 Mike

Here. So we we talked about the back to a Roth. Now we’re going to get into just the relatively more straight forward conversions and and. Just assume that you have that traditional account that you’ve been saving in for, you know, many years. Typically you know your 401K, your your high earning years, maybe you’re you’re putting your money in there or the TSP. And it it’s grown in size, you’ve got several $100,000, maybe close to $1,000,000 in there now. Well, that’s a big tax bill that’s sitting out there and eventually Uncle Sam wants his money and you know, in the out years now in your your 70s. You get forced to take a distribution because of that, so. What do you do? Well, if there is a time, maybe before you start taking Social Security, you retire your income drops and all you have is your pension coming in. That can make a great time to. Consider making a conversion and taking money out of the traditional side and just moving it over into. A Roth side. Pay the taxes, but again, if your income is lower, you’ll pay at a lower rate. So example. Dual military couple, both retired, have large TSP balances. They pushed it all into the traditional side basically because they were, you know they two incomes coming in at all times and. They’re 60 now. They don’t really need to work anymore. They decide they’re going to, you know, hang it up and and start traveling the world and figure they’ll they’ll wait and defer Social Security. At least, you know, full retirement age 67, maybe even all the way to 70. But they’ve got those seven years where all they’re going to have coming in is their pension. So they’re going to drop down into a, you know, relatively low tax bracket, probably the lowest they will be for the rest of their lives and. That can make great sense to start doing conversions where they’re taking money out of that TSP account and putting it into a Roth IRA and just paying the taxes on it and and if they break it up over those seven years, they could probably get a lot of that money out that relatively low. Tax tax rate.

00:21:31 Amy

Exactly. And so logistically, the way this works, you know, using this example where you have the two retired military spouses, most of their their wealth is in the thrift savings plan. They use the traditional version. So the pre tax version. You in order to do the Roth conversions like you explain Mike, in order to do that, you actually can’t do it inside of. So what you would do is you would open a Roth IRA at your favorite custodian, so some institution that you want to work with open that Ralph IRA and then you would request a distribution from TSP for the amount that you want to convert. So. You know, let’s just pretend like you’re going to convert $50,000. So you would you would request that distribution TSP would send it to the custodian. And now that they’re now TSP is going to generate A1099R so that tax form to tell the IRS that you’ve taken a distribution and you’re going to go ahead and pay tax on that amount of money, but it’s still in the retirement account and it’s going to be able to continue growing tax free. And you’re going to be able to take it out tax free later, because now it’s it’s Roth money. UM. So it seems counterintuitive to agree to pay this tax sooner, but you know, keep in mind in our example you’re you’re at a lower tax rate, then you will probably be in for the rest of your life. And this, you know it this takes a little bit of understanding how taxes. Work and being able to project things overtime to know that you are likely in a lower bracket and you’re and therefore you’re choosing to pay taxes at that lower bracket. Instead of at your higher anticipated rate leader.

00:23:28 Mike

Yeah, exactly. Yeah. It it’s important to understand that this, this takes a lot of analysis, understanding you know your current tax bracket. Where you’re going to be in the future considering some things like you know, what happens, especially if you got an age difference. You know when Exathe first spouse dies, or maybe someone’s not in good health and now they’re back in the single bracket. If money is going to be left to children, what tax brackets are they? And so very complicated. Nobody’s got a crystal ball on what? Congress is going to do with tax rates. So it’s it’s really the best guess of. Where you think you’ll be where you think tax rates will be and what? This often makes a lot of sense based on you know what we know today. This strategy can make a lot of sense and you know, really save. To hundreds of thousands of dollars in some cases. If you’ve got a very large, you know, 401K TSP Traditional IRA, those those taxes will, you know, it’s later in life can be significant so.

00:24:48 Amy

Yeah. And and there are so many factors that might change the landscape, I mean. Current tax rates, the reality is our current tax rates are historically low, but that doesn’t mean they’re going to go up. They might, they might not. I think that everybody is aware of the fact that we’re carrying more debt as a percentage of GDP than ever in our nation’s history. You know, we’re going to. Have to leave it to the politicians to figure out how we’re going to handle dealing with this. Is, is, is it going to be tax increases is going to be something else. But you know, that’s for politicians. That’s for economists to sort out. We near mortals trying to make decisions for ourselves. day-to-day. We have to make the best decisions we can with the, with the information we have available at the time. It’s not perfect. It’ll never be a perfect science because we can’t know the future. But we have to make the best. Decision with the info we have.

00:25:49 Mike

Exactly. So, Amy, we’ve talked about a few scenarios, you know, just basically when to, you know, possibly contribute to either either type of accounts. We’ve talked to the backdoor Roth and and also conversions. So just just curious if if you had a default. You know what you what would you recommend? You know, give some caveats or however you want to frame it, but do you prefer Roth, or do you prefer traditional?

00:26:23 Amy

Yeah, that’s a that’s a good question. And and honestly, I think a lot of people do leave this decision to a default. They just kind of use rule of thumb. So and oftentimes that default is pre tax or traditional contributions to their 401K or thrift savings plan. You know, of course, every. You know, every recommendation we make has to be tailored to an individual, so this isn’t a recommendation. But if I was forced to suggest like what a default would be. UM. I think I’d have to go with the Roth, especially for somebody who’s younger, like less than age 50, let’s say and and part of my logic there is that, you know, once you hit your 50s, oftentimes, particularly for military folks who retire and take a second career, when you’re in your 50s, you’re probably in your highest earning. There’s. But before that, there’s a good chance that you’re in, you know, a lower bracket than than you might ever be in. So we can’t know. UM. But just, you know, speaking in generalities, I think I would default to the Roth. You know, also because as I mentioned before, I think we’re at historically low rates. We have a big national debt. I’m not really sure how we managed to balance those books without. Raising taxes at some point I might be wrong again. That’s for politicians and economists to work out, but I think I prefer to know that, you know, to pick the devil I know, which is the tax, the tax pay, the tax of the rate that I know versus the devil I’ve yet to meet, which is to not know what. My tax rates going to be in the future. So I think if I had to pick a default, not a recommendation to anybody out there, but if I think I think if I had to pick a default, I’d pick. A Roth IRA. What about you, Mike?

00:28:18 Mike

Yeah. For a lot of reasons. I’m a big fan of the Roth and and I think that, you know, the age thing is good. I mean, the other, the other piece you can look at is, you know when you’re fire taxes. For you know, we just finished tax filing season. Go back and look typically like on the front page of something you get back from your accountant or get it out of any of the tax preparation software. It tells you what. Bracket you’re in and what your effective tax rate is. If those are low. If those are, you know 22, you know, if you’re in the 22% tax bracket or lower. I I have a hard time. Telling people not to, you know, recommending they possibly go into the the raw side, it’s it’s, it’s low. Like you said, I don’t, I don’t know how we get. In the future, and and don’t bankrupt our kids if we’re if we’re not, it’s at least in some ways, you know, raising taxes at some point so. And so, so look at that, you know, look at what your your effective tax rate is and and what your tax bracket is and you know make the decision. I I hate when I see you know people come in, they’ve been in the military 15 or so years and. You know, didn’t have the spouse, wasn’t working, so it was just a military. Income coming in and they’ve been doing traditional the whole time to get that tax break. That, that, that pains me because I’m like ohh you were paying at such low rates those first few years that it would have been so much better. Have you been putting that in Roth? But you know so again. Age is a good gauge, but but really just looking at your, your income and your tax rate and and making that educated guess and and like I said, if you’re borderline, if you’re in that 22% or pushing the top of that, maybe you split it, maybe do a little bit in one and a little. Bit in the other so.

00:30:28 Amy

Yeah. And that’s, I mean that’s a good, that’s a really great point. Trying to take a look at where you are and you know and and that’s sort of the trick and you know so. So you’ve heard our default sort of where we might default not recommendations for you specifically. But I think what I’d really like for you to take away from that is. Not to leave it to default.

We would rather you make an informed decision. We’ve talked about, you know, how complicated it can be and we’ve talked about tax brackets and you know, if this and then that and you know there’s a lot that goes into this decision. So it’s a little complicated. But we’re here for your questions. Drop us a line, you know, but be proactive. Try to make a good choice rather than letting some default, which tends to be sort of the traditional. But you know, don’t don’t do things by default. Make an informed decision.

00:31:24 Mike

Well, we we definitely appreciate you listening. Hopefully these two episodes on traditional versus Roth have been have been informative and you’ve learned something. And like Amy said, if you have any questions, you can definitely drop us a line and and let us know and. We’ll be happy to address them, possibly in. A future film. So Amy, it was great talking to you. Look forward to doing this again in a couple of weeks.

Amy

Sounds good, Mike. See you then.