Hello YNABers. My name is Jesse Mecham and this is podcast number 77 for You Need A Budget, where we teach you four rules to help you stop living pay check to pay check, get out of debt and save more money. Always wanting to save more money.
Today I want to end the debate that is incessant when it comes to traditional or Roth IRA. Some people say IRA [pronounced as a word] – I can’t do that for some reason. I’m the guy that says N-A-S-A for the NASA situation. NASA, N-A-S-A, IRA, I-R-A. I’m going with I-R-A. And if you don’t like that, we’re going to be talking about it a lot so you may want to change channel.
But, people debate constantly the difference between Roth and traditional IRA. They look and say, “Well, if you invest in a Roth IRA you pay tax on that money that you invest now, and then it grows tax-free, and then when you withdraw the money it’s all tax-free,” – the investment you put in initially, because you already paid tax on it at the beginning, and the growth that that investment experienced while riding around in that Roth investment vehicle.
On the flipside, the traditional IRA is a tax-deferred vehicle in which your investments ride around. So you would say, “Well, I’m going to invest that money,” and you deduct that money from your tax on your 1040 for that year, saving yourself some taxes that you would otherwise definitely pay. Then that money also grows tax-free until you withdraw it, at which point you pay money on the entire withdrawal – what you deposited or invested originally that was deferred from taxes, and then the growth that you had experienced that was also deferred.
Everyone would say, “Well, naturally the Roth is better because the taxes… the growth isn’t taxed.” But that’s not mathematically accurate. If I were to use really, really simple math – I’m going to get my calculator out for this one – let’s say that you were only going to contribute $1,000 to your… $1,000 you could contribute to your Roth. So you put in $1,000, you’re taxed at 25% though. So that $1,000, you really only could put in $750. Right? So you invest the $750 and it grows to whatever. The traditional IRA that you had the $1,000, you don’t have to pay taxes on that $1,000, so you end up contributing the entire $1,000 – $250 more than the Roth. They both grow at the same exact rate, same everything. At the end of the day, they will have – provided that your tax rate is the same as when you were going in – they will have the same amount.
Now, this opens up the question, and I’m going to loop back around to why the behavioral side of this is totally ignored, but this loops back to the whole idea of if your tax rate will be lower when you’re in retirement, then you should definitely be putting into a Roth. That makes sense. If your tax rate will be higher in retirement than it is now for your contribution, then you should be putting into a traditional IRA. That makes sense. It’s too bad that you have no idea what your tax rate will be.
I looked this up in the investing course that I was working on – the tax rate is all over the board. When it first started you would have made, I think, $425,000 in 1913 or so, maybe 1916, and you would have been taxed at 1% then. In 1944 that same person making $430,000 of inflation-adjusted dollars, they would have been taxed at 77%. Now I think it’s somewhere like 35%, the highest rate. We don’t know what the tax rate will be and you can’t pretend to know. We don’t know what Congress will do tomorrow, let alone what they’ll do 25 years from now when you retire. So the whole debate of will your tax rate be… I’ll admit that the tax rate will affect the financial ramifications of your decision, but you have no control over the tax rate, you have no insight into what it will be, so you should ignore it because doing anything else but ignoring it is kidding yourself. So, that removes the retirement tax rate from the discussion completely.
Now, let’s go back to that $1,000. You would not sit there and say, “Well, I have $1,000 but I’m not going to deduct it so I can only invest $750 because I’m doing this Roth.” You would just say, “Well, look, I’ve got $1,000,” and then you would invest it in your Roth. You would not, on the flipside, with your traditional IRA say, “Well, I’ve got this $1,000 here” – you’ve got the $1,000, there’s $1,000 in the bank account budgeted for, ready for retirement – but the $1,000, you would not say, “Well, that’s $1,000 but I’m not actually going to save tax money when I invest that $1,000, so my actual contribution should be $1,333.33 because if I invest $1,333.33 I will save myself $333.33 in taxes.” Right? That’s what you would do because you get that deduction. No one does that. Nobody does that. That calculation, if you want to know, was $1,000 divided by one minus your marginal tax rate – so in this case our marginal tax rate is 25%, so it’s $1,000 divided by 0.75. That gets us to our pre-tax situation amount that we could invest in the IRA. Nobody does that. You can see why – it’s confusing. My brain is oozing out under my keyboard a little bit here!
So, at the end of the day, because nobody does that we can’t consider honestly the fact that you would invest more in your traditional IRA because it’s tax deductable. You wouldn’t do that. You would just look to see what you have to invest and you would invest it.
So, why is the Roth better than the traditional IRA? It’s better because the limits are different. It will say in all the literature that you read that an IRA, Roth or traditional, I think are limited to $5,000 or something – I’m not going to spend the time to look it up, it will just change tomorrow or whatever. But the limits are $5,000. So you actually can contribute more to your Roth. It says that the limit is the same – it says that the limit for both is $5,000. And it’s true. You can only contribute $5,000 into a Roth or a traditional IRA. But to get that $5,000 for your Roth you had to earn… because you had to pay taxes on it already, you had to earn $6,667.67 – assuming 25% tax. So you are actually allowed to contribute more to your Roth because that will grow tax free and you’re capped at $5,000. You can’t go to the Government and say, “Hey, listen. You said $5,000 is all I can invest, but if I invest $6,667 that’s the money I saved, that $1,667 above $5,000 that I save, I want to be able to invest that too so that the Roth and the traditional are equal.” No, they’re not, because the Roth is tax free and you pay the tax upfront and the limits don’t reflect that fact. It’s better because tax rates in your retirement are off the table to invest in your Roth IRA.
Maybe I should have Casey [my tax and investing adviser] on here at some point. Maybe he could discuss that a little bit eloquently. But that’s my take on it and that’s why I like Roth. If you have a 401K with a Roth option, you should be doing that one. It’s just the same thing – 401K or Roth 401K limits, they’re both whatever they are, they’re both the same number, which means you technically can invest more in the Roth. And you should. Take advantage of that tax free growth, retire filthy rich, sipping some kind of a drink on a beach – I’m not much of a drinker, so I didn’t know what liquid.
Until next time, follow YNAB’s four rules and you will win financially. You have not budgeted like this.