Traditional or Roth: Breaking Down Retirement Accounts
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Just wait patiently and just see it grow and grow and grow exponentially until it's a giant pile of money and then you can retire and do fun stuff with it. Welcome to Stay Wealthy San Diego, a show for successful professionals doing all the right things with their money and are ready to take their financial plan to the next level. I'm certified financial planner Taylor Schulte and I'm here to teach you advanced financial planning strategies in plain English.

This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.

Welcome to Stay Wealthy San Diego. Today, we are talking traditional retirement accounts versus Roth retirement accounts. John's favorite topic. I love this topic. John, let me ask you something. Would you rather be out at Torrey Pines playing some golf or recording a podcast on retirement accounts? Definitely the latter.

What would you rather be doing instead of this? Um, gosh. Maybe jujitsu, maybe. Yeah, or, you know, reading a nerdy paper or writing a nerdy paper or...

calculating my expenses. I guess my point is we love talking about this stuff. I'd probably rather be on the golf course, but no, we do love talking about this stuff. And it's a really important topic. It's a question that we get a lot. People are faced with this option, whether they're investing on their own or in a company retirement account, they have these two options, traditional or Roth. And so we want to dive into that and help you answer that today. So

So today we're going to talk about a few things. One, which one is the better option for most people? We want to share with you why we think it's the better option. And then we also want to share with you the flip side of the argument so you can hear kind of what the other side says and inform your own opinion.

And then lastly, if you can make it to the end, we want to share with you a common misconception when it comes to investing in retirement accounts. And there's one super simple trick for finding the good investments in your retirement plan that we want to share with you that goes along with that. So stick around. We'll share that with you. I want to quickly preface that we're talking about kind of a complicated topic here and

everybody's situation is different. So I just want to say it probably goes without saying, but I want to say just understand the tax implications of everything we're talking about. If you need to talk to a qualified CPA or tax professional, or even your financial planner, because there's a lot of moving parts with this stuff. We're trying to break it down and keep it super simple. But sometimes things just aren't that simple.

So when you save money for retirement, you typically have two account options. And you've probably heard this before when you go to save for retirement. You've got the traditional option or the Roth option. First, we use qualified retirement accounts to save money because your investments grow tax deferred.

And that's why putting money into these tax advantage accounts is so critical.

because your money's gonna grow that much faster if you're taking advantage of this awesome tax treatment. Now on the flip side, that's also the same reason why dividend investing, for example, is such a bad investment strategy because taxes

can really affect your investment returns. And they do when you focus on dividend investing. Yep. So to recap, we use these qualified retirement accounts because of the tax benefit. You may, in some cases, pay taxes down the road, but while you're investing in saving, you get to defer those taxes. And that's really powerful.

So that's reason number one, while we're talking about retirement accounts. So again, when you save money for retirement, you typically have these two account options. You can choose the traditional account or you can choose the Roth. It doesn't matter if you're participating in your company retirement plan or an individual retirement account, also known as an IRA. You're typically faced with these two options.

traditional 401k or Roth 401k, traditional IRA or Roth IRA, traditional 403b or Roth 403b. You always have that option. So it's a really popular question that we get from people is which one's better? Which one should I do?

So today we want to dive into that and share with you again, which one for most people we think is best and why. So whenever there's a big complex financial planning question, for example, Roth or traditional, you're going to come across a rule of thumb. There's a lot of rule of thumbs in financial planning. Maybe some of you have heard of the 4% rule. How much money can I take out of my account every year? Well, an old study said 4% and now that's just become the rule.

Well, there's a rule of thumb when it comes to traditional versus Roth accounts. So let's talk about that rule of thumb now. Now, if you're young, if you're just starting your career, rule of thumb says you should use a Roth. Now, if you're older and you're at your peak earning years,

the logic dictates you should use a traditional account. And the reason why is because of the math. It makes sense. If you're young and you're starting in your career, you're probably earning less money now than you will in the future, which means you're going to pay less taxes now than in the future. So the Roth. And on the flip side, traditional, if you're earning a lot of money, you're in a higher tax bracket compared to what retirement's going to look like when you're earning less and will pay less in taxes. So rule of thumb for this situation,

question, it does make sense. But we're going to dig a little bit past the rule of thumb to see what really makes sense for you and your financial plan. Yeah. And John, I mean, you know, some people come across these rules of thumb, either they find it on Google or, you know, somebody shares these things with them. And they're not perfect, but they can be a good starting place. I guess speaking of good starting places, I

What we find a lot is that people default to choosing the traditional option, maybe just because traditional is a word they understand and nobody knows what the heck Roth means. So they choose traditional. But, you know, at some point along the way, someone told them that the traditional option gives them a tax break and Americans love their tax breaks.

They hear that and they assume it's a good thing. So they grab it. So they take the traditional option and they take that tax break. Other times people default to the traditional option because it's just the default option. When you enroll in a company 401k plan at work, that's just what they give you. If you don't check any boxes, that's the default option.

Tax breaks can be good. Tax refunds are nice. We all want to keep our taxes lower and we'll definitely be diving deeper into taxes as this podcast progresses and talk about some ways for you to reduce your tax bill. But a tax refund is,

isn't always a good thing, is it, John? No, especially if it can grow into a monster tax liability in the future, which we'll talk about a little bit later on in the podcast. So we want to share two examples to kind of kick things off here as we sort through which is the better option, a traditional or a Roth.

So we're going to share two examples with you. The first example is an example of using the traditional option. And in this case, we're going to assume it's a traditional 401k. So you work for a company, you have access to a 401k, and this year you're eligible to put in or contribute $18,500 into this account. So that's the maximum amount that you can put in.

So you choose the traditional option. You contribute $18,500 into that account this year and you get a tax break. That tax break can be several thousands of dollars depending on your tax bracket.

So you get this tax refund, which is nice. But the problem is, I think most of us can agree that most people probably end up spending that tax refund, you get a tax refund, and then it kind of just disappears, you have a lower tax bill for that year. But what did you end up doing that 1000 or 2000 or $5,000 tax break that you received?

Most people don't have a system for getting that tax refund and then reinvesting it and earmarking it for retirement. Here is why that's a problem. When you go to pull money out of this traditional 401k or any traditional retirement account, when you go to pull money out during retirement, you're actually taxed on that withdrawal.

Let's just assume you put that $18,500 in, let's just say just for the sake of keeping numbers really simple, the money didn't grow, you didn't add any money, 10, 15 years down the road, you go to take money out during retirement. When you go to take out that $18,500,

you're taxed on it so 18 500 minus the taxes you pay is what you actually get in your pocket so you didn't actually really save eighteen thousand five hundred dollars you only saved eighteen thousand five hundred dollars minus that same amount multiplied by your tax bracket right so if you choose it a traditional option and you get that tax refund

you might start thinking about what am I going to do with that tax refund, calculate what that tax refund is, and then make a plan for it. Don't just let it get lost in your tax return or spent on a vacation or, you know, sometimes it just completely disappears. So have a plan for that tax refund and make sure that that refund is being reinvested somewhere and earmarked for your retirement because that contribution is going to get taxed down the road.

So let's compare that to putting money into a Roth. You work at the same company and instead you decide to put money in the Roth 401k. You have the same maximum contribution of $18,500. The difference is, is when you put that $18,500 in, you don't get a tax refund.

But when you go to take that money out in retirement, you don't pay any taxes on qualified withdrawals. So again, our super basic example, you put the $18,500 in, it doesn't grow, you don't add any money. Just again, keeping things simple, you go to pull that money out, you actually take out the full amount and you don't pay any taxes on it. So you have more money in your pocket at the end of the day when you go to take money out.

Yeah, you can't argue with literally having more money after taxes. I mean, who doesn't want to have more money in retirement? Now, the other thing to think about is with the traditional account. If you say, yeah, you know, I'm really disciplined. I'm going to invest my tax refund. Okay, great. Go ahead. Use the traditional. Invest your refund. But now the catch is that you're not getting tax-advantaged growth anymore.

on that refund. And that's the whole point of raising these accounts in the first place. So if you put your money into a Roth, then all of your money gets tax advantage growth. And as we know, taxes slow down the growth on our investments. So we want more money in the account rather than less. Yeah, that's a really, really good point, actually. Yeah. So you get that tax refund and now you want to invest it. Well, it's got to go in a taxable account. So now you're going to pay more taxes on the investments there. So

Well, you know, for me, you know, the moral of those examples really is if you're going to use a traditional, just make sure you have a plan for those tax refunds. So if you haven't really caught on yet, we prefer the Roth option for most people. And we shared with you just that one example, but we want to share with you some other reasons why we think the Roth option is generally better.

So the first reason was expressed in those examples. You just, you simply save more money. It's much easier to save money. You don't have to think about what to do with your tax refund or tracking it down. You just simply save more money.

Reason number two, you don't have required minimum distributions. And this is huge. Now, of course, this applies to a Roth IRA. You've got to roll your other Roth accounts, be it a Roth 401k, Roth 403b, et cetera, into a Roth IRA to take advantage of that strategy. But that's not very difficult to do. But when you don't have any RMDs, you're

your life in retirement becomes a lot easier. Recently, we met with a gentleman approaching, I want to say 72, and he just had tons and tons of money in a traditional IRA, which means his RMDs are in full effect and he's paying tons of taxes. And he came to us because he needed help with taxes. He had so much money.

in his traditional IRA that he honestly didn't know what to do. So in addition to not having to pay taxes on RMDs, which is never fun, your money also gets tax deferred growth forever with a Roth IRA. Since the money never comes out, it keeps growing and it keeps getting that fantastic tax treatment. Now with the traditional account, you're only gonna get this tax advanced growth for a limited number of years,

And that's going to be as soon as you turn 70 and a half to when you put money into the account. Yeah. And in case we glossed over that in a traditional retirement account, whether it's a traditional IRA or traditional 401k,

At age 70 and a half, you are forced, the IRS forces you to start taking money out. And again, when you take money out of a traditional retirement account, you're taxed on those withdrawals. So you cannot defer your taxes forever. At some point at age 70 and a half, the IRS says, we want our money. And they force you to start taking out little bits at a time. And now you have a higher tax bill.

So again, with the Roth option, you don't have those required minimum distributions. You can literally defer your taxes forever. And if you're a really good saver, like this gentleman John referred to, if you're a really good saver and you've generated a lot of wealth and you're set for retirement, you're going to have to defer your taxes forever.

There are years where you don't need to take money out. And it's better if you have that option, rather than the IRS telling you, you need to take money out and pay taxes. So that kind of leads us to our third reason, which is flexibility, because you don't have...

a lot of these rules that the traditional has, you have more flexibility. One option is you can take out your principal contributions at any time. So if you put $10,000 into a Roth account, you can take that $10,000 out. And John, I think you actually did this to buy your first home. Yeah, it's both my wife and I, we did this. We had Roth IRAs and we can

Maxed it out over the course of several years and the account grew over and above what we put into it So we were able to take out what we put into it That's one of the advantages of using a Roth IRA We were able to take out one the original amount we put in but also an additional 10,000 as first-time at home buyers that really helped us put down a huge down payment and now I don't have to worry about a massive mortgage just because we're able to put a bigger down

By having the money in a Roth, you're able to take it out free and clear without the penalty and without paying income taxes on it. So it gives you some nice flexibility. But there's also some flexibilities for tax planning as well. Yeah, absolutely. If you don't have RMDs, you can have other income without being pushed up into higher and higher tax brackets.

One thing is that when you're in retirement, RMDs aren't necessarily going to be the only thing that's going to be generating income for you. Most people, well, at least I hope our generation is going to have Social Security, but a lot of retirees have Social Security now. Some folks have pension income if they're lucky enough. And of course, with both Social Security and pension income comes taxes, right?

Maybe you have a plain vanilla taxable account because you're such a good saver and you've maxed out your tax advantage accounts and then you've put some more money in taxable accounts. That's going to generate taxes too. If you're a business owner having an S-corp making dividend distributions, that's going

That's going to mean more taxes for you in retirement. And if you've amassed just one or maybe even a handful of rental properties, that's more taxable income. So the last thing you want when you have these multiple income streams that are all taxable at be it the ordinary rate or even at preferred rate for dividend distributions, the last thing you want is more taxes pushing up in a higher tax bracket.

And if you shovel money away into a traditional tax-deferred account, be it traditional IRA, traditional 401k, that's what you're looking at. You're looking at huge potential tax liabilities in retirement. So before we share our last reason why we think the Roth is better, let me just recap those four reasons. Number one, using a Roth option.

IRA or Roth 401k or Roth retirement account, you will save more money over a long time horizon. Reason number two, you don't have required minimum distributions. These are also known as RMDs. Reason number three, there's a lot of

added flexibility, whether it's taking money out to buy a house like john or to start a business or just maybe something dramatically changes in your life, you have the ability to take money out and use it for other purposes and not be penalized. Reason number four, you might not be in a lower tax bracket during retirement, social security might kick in, you might have pension income, you might have business distributions or rental property.

All these things could put you in a much higher tax bracket than you had anticipated. All right, so our last reason, reason number five why we generally like the Roth retirement account. This is John's favorite. We call it compounding your tax bill. Yeah, so the reason why we invest is because we can put a little bit of money in and just wait patiently and just see it grow and grow and grow exponentially until it's a giant pile of money and then we can retire and do fun stuff with it. So that's why we invest because...

the growth of our investments is just so amazing. But the flip side is that if you use a traditional tax-advantaged retirement account, again, be it an IRA, 401k, et cetera, not only are your investments compounding into a phenomenal amount, but so is your tax liability.

Essentially, you're trading what's a small write-off when you make the initial contribution to something that's going to grow and grow and grow right alongside your investments. The bigger your investments grow, the bigger your tax bill is going to grow. Yep. So we've shared with you the five reasons why we love the Roth accounts.

But as you can imagine, there's two sides to every story. So we wanted to share with you that the flip side of the argument, there are a lot of people out there that say in some cases or a lot of cases, the traditional option is better. So we want to share a few of those with you so you can make your own educated and informed decision and decide which one you think is better or which one might be better for you. So one of the counter arguments to the Roth is

is that future tax rates are unknown. We have no idea where taxes are gonna be in the future. So take your tax refund now, especially if you're earning a lot of money and you're in a high tax bracket in today's world.

take that tax refund now because we just don't know where future tax rates are going to be. Yeah. Historically, tax brackets have been all over the place. The marginal rate was 90% in certain years. So given that it's so volatile, right? Tax rates are so volatile. It may make sense to

go for a bird in the hand versus two in the bush. So the second reason why you may want to jump on the traditional tax deferred account as opposed to the Roth, and this is a funny story for me to share because I got a lot of pushback when I shared my Roth article on the internet.

And that is if you are a super disciplined investor, if you are on the track for early retirement, there is a pretty neat strategy you can put into place where a traditional investor

tax deferred account makes sense. Now, if we go back to our rule of thumb, right, it says if you're young, use a Roth. But we like to say, use the Roth pretty much in every scenario. Well, if you're on the early retirement track, then and you're super disciplined about it, then the traditional IRA can make sense. Real quick, let's let's explain this early retirement thing. Because you know, you mentioned you got this argument on Facebook, it's because there is a community out there

they call themselves the FIRE community, right? What does it stand for? Financial Independence Retire Early. So it's a large group, a community of people across the world that have this passion for retiring at a really early age. Absolutely. And it's a really, really smart crowd of people. And a

A lot of finance 101 or a lot of really common financial planning advice sort of gets flipped on its head for this group just because they're doing things so differently. So for them, using a traditional account may make sense because there's a really interesting strategy where you can shovel money into a traditional account, lower your tax bracket, retire early, have no income for several years, do Roth conversions annually, and

Then after the fifth year of doing that, you can take your principal distribution out because we talked about how you can take principal out of a Roth account tax-free. And we'll put a link in the show notes from a mad scientist post that talks all about this. So if you are an ultra-disciplined money nerd, then probably the Roth strategy may not make sense for you. We said our goal for this podcast was to take advanced tax

planning concepts and make it super simple. And we're definitely not doing that with this counter argument. Like John said, this is for ultra disciplined,

money nerds, people who really understand this stuff are spending a lot of time on it, or they have somebody that's helping guide them through this type of strategy. And it can make sense. So just know that there is a place for it, but you just have to understand all the implications around it. Sure. So to cite another reference, Clark Howard, wonderful personal finance guru, he

He says that it may make sense to split the difference. Put some money into a Roth account, put some money in a traditional account. He makes the case that'll give you a little bit of flexibility when retirement comes around. And another thing to think about is that sometimes you can only put money into a traditional account. If you're a small business owner, you can only put money into a SEP IRA. There's no Roth SEP IRA. So,

When it comes to your regular IRA, use the Roth. And that way you can split the difference there. And we see this a lot. There's these, I call them, you know, textbook answers and then kind of real life answers. And we see this a lot in real life. Sometimes it's just people have a hard time wrapping their head around this Roth concept. Like it's just hard to get. It's just ingrained in their head to just take the tax break. Tax breaks are good. I want the tax break. And so sometimes it's really hard for them to wrap their head around the math

behind all of this. And so sometimes the easy answer is just split it, right? Put half your contributions in a traditional and put half your contributions in a Roth. And you can do that in your employer retirement plan. You can split it. So if you're kind of on the fence, you're not really sure, that's certainly an option there. Final reason, flip side of the argument for the Roth. And this was inspired by Taylor's comment earlier that people put money into the original because of the tax break. So

So if getting the tax break means I can get you to save for retirement, then putting money in traditional 401k is better than putting no money into a Roth 401k because you don't get a tax break. So from the human behavioral finance perspective, if getting a tax break today is what it takes to make you save money, then

Let's go for the traditional account all the way. So the counter arguments for the Roth to recap, future tax rates are unknown. That's number one. So take the tax refund now. Argument number two, if you're really disciplined with your money, you really understand this stuff, you're willing to put in the time or you're willing to hire somebody to kind of guide you through each step of the way.

There are some strategies out there where you can use a traditional at a young age and then convert to a Roth as you get older. Again, that's really popular in the early retirement community known as FIRE. So you can Google that and read around. We'll also try to link to some of the show notes. The third counter argument was that you could split the difference. There are a lot of unknowns in this strategy and both strategies. So you might split the difference and put half and half.

And then number four, as John just shared, there's kind of a behavioral finance thing here. Whatever it takes to get you to save money, we'll take it. So if it just feels really good to put money in a traditional account, that's all you know, it's all you were taught, that's better than doing nothing at all. So hopefully you've stuck around this long. We wanna share with you kind of a common misconception. One of the things that we see a lot is people

people think that when you contribute to a retirement account that you're done. You put money in the retirement account and then it's automatically invested. You don't have to do anything else. But that's actually wrong. There's actually a second step. You have to put money into the retirement account and then you have to go in and then invest that money. If you don't invest that money, it'll just be doing nothing for you. And we've actually seen...

We have a number of statements across our desk, just money sitting in cash because people thought they put money into their retirement account. It just never got invested in it, sat in cash for, gosh, sometimes long periods of time. Yeah, it's just heartbreaking just because these tax advantage accounts, the tax treatment is just magical. They can just grow and grow and grow without the government getting in there and taking their cut. And that means more money for you more quickly. So-

Yeah, you have to not only put money into your account, but you have to invest it as well. So think of it this way. The IRA account, the 401k, that's the wrapper. That's the shell. And what goes inside, those are the investments. So you have to choose a wrapper. And then once you've chosen the wrapper, you have to choose the investments.

So we want to talk a little bit about investing your contribution. And we'll definitely have a lot more episodes on investments and diving a little bit deeper and how to improve. But just for today, since we're short on time, we want to provide you a little bit of guidance. So when you put money into that retirement account, whether it's a traditional or a Roth,

Sometimes you're limited to a small menu of investment choices. If you're investing through a company retirement plan like a 401k or 403b, usually they give you an investment menu and maybe there's 10, 15, 20 funds to choose from.

Other times you have access to thousands of options through your IRA and your IRA could be held at any brokerage firm that you choose, whether it's a Schwab or Fidelity or any of those big names that you know. So either way, the one thing that you want to make sure that you do, and this is actually a really good place just to start when you go to invest your money, is to screen those options for the lowest cost options.

Again, I don't care if you're investing at Schwab or Fidelity and there are 5,000 different investment options. They will provide you a menu, whether it's online or Excel format. And number one, we want you to screen for the lowest cost options and start there.

And we've shared this before, but the reason why we say start with the lowest cost options is because historically, lower cost investments tend to perform better than higher cost investments. So again, we're trying to put the odds in your favor. Are there situations where high cost investments do better or certain time periods or certain funds? Absolutely. But we don't know what the future holds. And so again, we want to tilt the odds in our favor.

Also, a lot of times in these company 401k plans or 403b plans, there are some nasty, nasty investment options. So you need to look at what it costs to invest before you just start putting your money in there. The term that you want to look for when you're searching for what the cost is, is it's called an expense ratio.

So you're going to look for the expense ratio for each of the available investments. And you're going to start by looking at the cheapest options available to you. All else being equal, the lower cost investment is better.

Taylor mentioned that on average, lower cost investments do better. Now, sometimes, yeah, there are going to be some outliers, but consider the odds. It's about roughly an 80% chance that the lower cost fund is going to do better. So I like those odds. If I have an 80% chance of something over something else, I'll take the 80% chance all day long.

Now, low cost investing is one of the critical rules, if not the number one rule of investing. You absolutely must keep your costs low. That's going to help your investments grow quicker in that tax advantage account or in all accounts. Now, another huge rule of investing is diversification. We want to spread our risk faster.

among not just one, two, or three, but as many low-cost investments that we can find. Now, depending upon your company retirement plan, be it a 401k, 403b, et cetera, or if you're an IRA, you have a lot of options, you want to diversify across as many asset classes as possible. So for stocks, that means you can choose U.S. stocks, you can choose international stocks, you can choose emerging market stocks.

You can choose large companies or small companies. You can choose real estate, and that'll often be abbreviated as REIT, which is short for Real Estate Investment Trust. And then you should also be able to invest in bonds. Sometimes you'll be able to choose a bond fund that has every single bond in the world. Sometimes you'll be able to choose a bond fund that's just U.S. government bonds. But you want to diversify across the different types of investments to help decrease your risk.

Yeah.

we're not saying to go into your retirement account and just buy 10 different funds. You do need to know what you're buying and why you're buying it. So John mentioned a couple of the different asset classes. What we're trying to do is we're trying to invest in different types of asset classes so that when one zigs, maybe one zags, and you have a nice blended rate of return. So we don't want to just go in and buy 10 US stock mutual funds.

But we might look for a US stock mutual fund, an international fund, maybe a large cap fund, a small cap fund, and some other asset classes. So hopefully that clears up any confusion there. Yeah, Taylor made a great point. So let's take these two rules of investing, let's marry them together, and how they can work in your 401k. So one, we want to keep our costs low. And two, we want diversification. So take a look at all the US mutual funds in your 401k, find the lowest one, get

get some of that. Then look at all the international funds, find the lowest cost one, put some of that in your portfolio and on and on it goes until you have a low cost diversified portfolio. So hopefully we provided some valuable information to you today. Most of you are probably already investing in a traditional account or a Roth account or maybe a blend of both. So I hope we've kind of opened your eyes to some new concepts that you hadn't heard before. Um,

You can always change things up today going forward. Don't feel like you made any big mistakes in the past. Again, we hope you found this really helpful and valuable. If you have any questions for us or you have a question of your own, you can email us at podcast at staywealthysandiego.com. We personally read every single email. So if you have any suggestions, any questions, any follow-ups, please shoot us an email and we will get back to you.

So thanks so much for listening. We appreciate your support and we will be back here in two weeks.