When to Use Roth vs. Traditional 401k
Watch Erin Kennedy and Luke Bertke from Eikenberry Retirement discuss the difference between a traditional IRA and a Roth IRA. Luke explains that with a traditional IRA, contributions are tax-deductible in the year they are made, but taxes are owed when the money is withdrawn in the future. On the other hand, with a Roth IRA, taxes are paid on the contributions in the year they are made, but the money grows tax-free, and withdrawals are tax-free in the future.
Luke goes on to discuss how additional tax rules will affect these accounts in the future. Luke emphasizes the importance of tax diversification and how taking IRA distributions in retirement can affect the taxation of Social Security benefits. For guidance or help planning and understanding one’s current and future tax situation contact Luke and the team for your retirement needs here.
Erin Kennedy (00:16):
Hello and welcome to Retirement Wealth Academy. I’m your host, Erin Kennedy. Thanks for being with us. This show is dedicated to helping retirees and pre-retirees sort through the many complicated questions and topics surrounding retirement. And for the answers, we turn to local experts. Today we have Luke Bertke. Luke, good to see you. Good to have you back.
Luke Bertke (00:32):
Yeah, nice to see you again, too.
Erin Kennedy (00:35):
I like to talk to you because you have such a great way of explaining the basics, and I want to get down to a real basic question. What is the difference between a traditional IRA and a Roth IRA?
Luke Bertke (00:45):
All right, traditional IRA, in the simplest of terms, you are making contributions into a retirement plan, and you are writing that amount off of your taxable income in that year. With a Roth IRA, you’re paying the taxes on that money in that calendar year, then investing it into a retirement account. The Roth IRA then grows tax-free, and you take your tax-free distributions in the future, whereas with the traditional IRA, you haven’t paid taxes on that money yet, so when you take it out in the future, that’s when you owe your income taxes.
Erin Kennedy (01:16):
I’m always very concerned about the here and now, though, so why would I choose to pay my taxes now?
Luke Bertke (01:21):
So I would say a general rule of thumb or a general thought out there that you just put as much into your traditional 401(k) as you can.
I was taught the same thing when I started my first job. You get a 401(k) match, put what you’re comfortable with in there, get your match, and go from there. A lot of people don’t consider that early in your working years or maybe even later with current tax brackets, if you’re in a favorable tax bracket at the time that you’re making your retirement contributions, why not pay the taxes now, whereas your income could be higher in the future where it might make more sense to pay the taxes now in some historically low brackets and/or your income being lower now than you hope it would be in the future.
Erin Kennedy (02:03):
Right. Do you think taxes will go up in the future?
Luke Bertke (02:05):
Maybe I’m a pessimist, but I do. With national spending, our national debt where it’s at now, there really is no choice but for taxes to go up, in my opinion, and what we have right now is relatively favorable compared to historic rates, as well.
Erin Kennedy (02:21):
And I understand that tax diversification is important, but it’s really hard because, as you mentioned, we’ve been taught to sock your money away in a 401(k), and then when you hit retirement, it’s like everything changes and that’s why that tax-free money can be really important.
Luke Bertke (02:35):
Yeah, because it can have an effect, not only obviously on your income tax picture, but it can affect so many other things, as well. A lot of people fail to realize that by taking IRA distributions in retirement, it could affect the amount of your Social Security that’s taxable.
So even though you’re maybe getting taxed in a 12% bracket, as an example, your effective tax on that distribution could be 18, 20% because it’s resulting in an extra amount of your Social Security being taxable, as well. So this ties in with what we’ve talked about in the past of, are you really going to retire in a lower tax bracket than what you’re in right now? Maybe, maybe not, depending on your income sources, but for a lot of people, the Roth IRA does make sense.
Erin Kennedy (03:14):
And it comes back to that proactive planning.
Luke Bertke (03:16):
Absolutely. Knowing where you stand now and having a good estimate of where you’re going to fall in the future.
Erin Kennedy (03:22):
Perfect. Okay, Luke, thank you so much for explaining that.
Luke Bertke (03:24):