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Individual Retirement Account (IRA): Roth vs. Traditional


In today’s episode, I’m interviewed by Matt Robison in his on-air radio show Your Money - where we discuss Traditional IRA vs Roth IRA.  Where should you invest your money?  Which one makes more sense?  And be sure to listen to the end where we talk about Roth Conversions and Backdoor strategies. 

Topics Covered

  • What is an IRA?
  • What is the difference between a Traditional IRA and a Roth IRA?
  • Which type of account is best?
  • If I’m young and starting my career, should I use a Roth?
  • What if I’m in the middle of my career or about to retire?
  • What is a Roth Conversion and when should I do that?
  • What is a Backdoor Roth?

Photo by Ben White on Unsplash


Matt: [00:00:25] Welcome to real financial planning, broadcast on WKXL. Available wherever you get your podcasts. I've got Mike Morton here of Morton Financial Advice. Mike welcome back. 

Mike: [00:00:38] Thanks Matt. It's always great to be here. 

Matt: [00:00:40] So we were talking about what we should get into in the broad world of personal financial planning.

There are so many topics that people ask you about all the time at sort of an intro level. And I thought it would be really helpful to walk through the basics of retirement savings. And I'm going to start out with a really basic question. What is an IRA? 

Mike: [00:01:03] always good to start with the basics and build up from there.

So IRAs,  when you're reading the news, what is this organization? It's actually the individual retirement accounts.  . So it is a retirement account. Now your employer you're probably used to when you first take that job, right? They say, Oh, we've got a retirement account, a 401k, or a 4 57.

And do you want to auto contribute some of your income into that account? So those are retired. Those are employer retirement accounts, but this is an individual retirement account. So the government has created these types of accounts that you own. They are owned by individuals, not as a family or joint.

So individual owns this account. You can put money into it, you can invest that money and it can grow. And then you can use that money to fund your retirement. That's what it's about. And then of course, there's lots of rules around what you can do with the IRA, the individual retirement account, but at the basic level is another savings mechanism where you can save and fund your growth for retirement.

Matt: [00:02:08] Got it. Now. When I see IRAs, I see two kinds. Traditional and a Roth, which always makes me think of the, a gangster from godfather to what is the difference between a Roth who I'm assuming is not a gangster and a traditional IRA. 

Mike: [00:02:28] There are two different types of accounts. That's right. And even in your employer, retirement account, we were just talking about the differences between employer and individual retirement accounts.

There are these two types, traditional and Roth, and those words mean very specific things in this case. And it's all about the taxes.  In the ,  traditional retirement accounts, you pay your taxes later, right? So you get to defer those taxes. Whereas in the Roth, it's the exact opposite.

We're going to get into the details, but you pay the taxes up front. So the bottom line is it's all about your taxes. And if you know the tax situation you're going to be in throughout your life, then which one you would go for, you would exactly be able to answer that. Because of it's the same math that works out.

However, we don't really know what our tax situation is going to be. You can pretty much figure it out for the current year. What kind of taxes you're going to be paying on your income, but unfortunately it's hard to predict your future income, especially when we're talking 10, 20, 30 years out for retirement.

And the other real problem is predicting tax rates. So even if you can think, Oh, my income will be going up over time. So maybe my tax bracket will go up over time. Who knows what the government is going to be doing in terms of tax brackets. So that's this podcast and the difference between Roth and traditional, we're going to be talking a lot about your tax rate because it's all about the taxes.

Matt: [00:03:53] .  Probably never really existed, but the, the traditional career path of yesteryear where, Hey, I'm going to work for company X for the next 40 years. So I pretty much know what's going to happen here. That's not really the situation anymore. Okay. So I can't predict the future.

So I have to make this choice right. It seems like I probably should make this choice. So I want to retire someday. Where do I start? 

Mike: [00:04:14] So you start with whether you want to pay your taxes to the government now or later. That's you remember those candies now and later, whatever happened to those candies?

Do you remember? You 

Matt: [00:04:23] remember that? I don't know. Candies. I have to admit, I found them exceptionally disgusting. They were totally market corrected by Starbursts. Starbursts are better at every single way, but all right, so you're making a point. That's not about candy and I think it's about retirement, 

Mike: [00:04:40] right?

So the it's all about taxes and these accounts work like this. The traditional accounts, you will contribute money to that account from your income. And you get to take that income and deduct it on your tax return. So in other words, you are not paying taxes on that money, So that's important to know in the traditional individual retirement account, you put in $6,000, you contribute $6,000 to that account.

You do not pay taxes on that $6,000. Then it grows, hopefully invested. It grows over time. And eventually when you take it out, the government is going to want their money because it was income. And so when you take that money out, that's when you're going to pay taxes. 

Matt: [00:05:20] Sounds like the advantage here is you're putting in more now and because of interest it'll grow, you start with more, it should grow more.

Mike: [00:05:30] It grows about the same in a sense. And I'll get to that in a minute. Oh, I see. You can put in 6,000, it's just that you pay less than income taxes. And you might owe $1,500 on that 6,000 and so  you do not have to pay that 1500, so it's $1,500 in your pocket. That's in your checking or savings account.

You're probably going to spend that money Matt. Okay. Because you just got it as you didn't have to pay it in taxes. And so it's sitting in your account and you're going to spend that money. So that's how the traditional works. You get to put in the whole 6,000. Now, the Roth is the exact same in terms of you putting the 6,000, but you're going to owe that $1,500 in taxes upfront.

So the Roth works exactly opposite. You put in $6,000. Into your Roth account, which you do not get to deduct it off your taxes. So when that, when you're filing your taxes next year, you owe income taxes on that 6,000, it still grows tax free same thing within the account, as it grows over the next couple of decades, then when you take it out, you've already paid taxes on that money.

And so therefore comes out tax-free we only get to pay taxes once. And that's important to know in either account, this is income that you're putting into these accounts. So it shows up on your tax returns one way or another. And you're either going to pay the taxes at the beginning or at the end, but you're just going to pay at once.

Matt: [00:06:46] All right. So if I am going to pay now, Or later, and let's say, let's just assume for a second that I could predict my income and my tax rates. And there'll be similar now and in the future. Which is better, right? 

Mike: [00:07:03] Yeah. So now it gets now it's suddenly confusing. Wait a minute. Even if I can predict all these things, which one works out better?

It turns out that the math is exactly the same. So if you're in a 24% tax bracket now, And you put in money in one way or the other let's compare, traditional Roth. And then it grows a compounds for 20 years, 6% or whatever it is, and then you take it out and you're still in a 24% tax bracket and you take it all out.

You will end up with the exact same amount of money in your pocket. And that's because if you go back to your high school days, it's the communitive property. It's all multiplication and division in this case, all the numbers. And so the end result is exactly the same. Again, if you have perfect knowledge and all the numbers are stay the same throughout time.

Matt: [00:07:49] All right. Now I'm back in the real world where I don't have perfect knowledge, which has demonstrated pretty much every day. Let's try out some situations then, because we, so let's say I'm young. That would be nice. What should I think about, or do. If I'm in that kind of a profile from starting out in my career.

Mike: [00:08:07] So if you're young and just starting out in your career, twenties, thirties, it could be forties. You still have a long runway of time. You're probably in a lower tax bracket. You're probably in a place where you're just starting your career. You've been maybe work in five or 10 years, still growing that career, hoping to make more in the future.

And so if you're in that smaller tax bracket, lower tax bracket, That's a good time to use the Roth. Remember the Roth versus traditional is all about paying taxes when your tax rate is the lowest. Okay. That makes sense. If I'm in a 12% tax bracket now, and I expect to be in a 24% tax bracket later, let me pay the taxes.

Now, traditional versus Roth allows you to decide. Somewhat with some amount of money when to pay your taxes. So let's be smart and pay it when you're in a lower tax bracket. So if I'm young and just starting out, I could be in a lower tax bracket hoping to grow that in the future. And that's a great time to use Roth .

Lower tax rate, pay the taxes. Now it's hard to think about when you're young, right? Paying your tax, paying taxes. I don't want to do that. People like to just pay exactly what they owe no more. And so it seems like a good idea to save on those taxes, but remember, it's all about predicting the future as best as we can.

And when we're in the lower tax bracket, let's pay the taxes at that time. 

Matt: [00:09:24] That makes a lot of sense. So let's say. I am a little bit less young and at a certain point, my income starts to go up. At what point do I make a switch? 

Mike: [00:09:36] Yeah, this is where it obviously becomes tricky because these things it's like the slow boil, these things gradually changed.

And so when should I jump out of the hot water as it goes up, it's really hard. That's a hard question to answer, but if you can take a step back and think about your career. And think, okay. Here's where, here's where I've been doing Roth for 10 years now. And I've gone from a, 18%, 20%, 22%, it's kind ticking up.

Now's a good time to switch over. The other thing we'll get to a little bit is the different types of accounts. And if you have a lot in the Roth already, You want to get some money into the traditional account as well. You want to take advantage of multiple of these accounts. 

Matt: [00:10:19] Why is he, so I shouldn't necessarily put everything into the Roth.

If I'm young, 

Mike: [00:10:24] it's not an all or nothing. Okay. So you can mix and match and put a little bit into both. You can even do a 50, 50, I'll put 3000 and traditional 3000 and Roth. And that's not a bad strategy again, because having some money in various types of accounts can be very useful in the future. But when you're young, I would still say if you're in a lower tax bracket, expecting that to go up, I would go a hundred percent Roth until a little bit later on.

Matt: [00:10:49] And let's say I have been saving for a while in a traditional IRA or a 401k, for example that's something I actually know a little bit more about 401k. So if I'd been doing that for a while and I started when I was relatively young, now I'm mid career. Should I switch now? 

Mike: [00:11:09] Yeah.

There are a few things I would think about. Let's mention three things that I would consider when you're thinking about okay. A mid-career my tax them and standard middle tax bracket. Now the first is the tax rate because it's going to keep going up over time. And so you want to really consider that?

The second thing I would think about is that is the. Different types of accounts, the different tax buckets. So let me talk about this for a minute. There are three different tax buckets, three different tax types. When it comes to accounts, there's the traditional, which I've told you, you pay your taxes later.

You get to defer those taxes. Which always sounds wonderful. I like kicking the can down the road. So those are called tax deferred accounts. There are the Roth. , rip off the bandaid, pay the taxes upfront. Those are tax-free accounts because once the money is in there, it is a hundred percent your money.

You have paid taxes on it. It's compounding tax-free. You're going to use it when you take it out. It's going to be tax-free. So that sounds wonderful. I love that those are tax-free accounts and the third is a taxable account. These are your regular checking savings, brokerage accounts. And , those are taxable.

So every year as you get interest in dividends, you're going to pay taxes on that. And then you have capital gains on those. So there are three different tax types when it comes to accounts. It's good to have a mix of all three. And the reason is as you get older, it just makes for more planning opportunities.

When it comes to tax strategies. If I only have one tool in my tool chest, if I got a hammer, everything's going to look like a nail. And then I don't have a lot of things that I can work on. But if I have three different tools at different points in your life, you can manage those. And that's where you can really do some great tax savings.

Matt: [00:12:52] All right. So I want to talk about those buckets. I love a good bucket conversation, but it, can you just put in a nutshell for me? Cause I'm actually in this in this boat mid career what's the take home on it. 

Mike: [00:13:04] In what sense? What do you mean? 

Matt: [00:13:05] What's the, what's the sort of the sum-up for what you should be doing, if you're mid career, it sounds like you want some diversity.

Mike: [00:13:13] Yep. Yeah. That's the main thing to look at is that diversity, because a lot of people get caught in, Hey, I've been putting away in the 401k for a long time.  Started my career took that first job they gave me the paperwork, filled it out and 10 or 15 years later, it's like, Oh, I built up some good money in that 401k.

I really haven't done that individual retirement accounts. And maybe that was all traditional because the Roth a little bit newer. So you can easily find yourself in that situation where all of your money is in that tax deferred. So that's a good opportunity to start thinking about, Oh geez, I don't have much in the tax free bucket.

And so let's take advantage of that and maybe pay some taxes now and get some money into those tax free accounts. So that's one thing that I would certainly consider. The other thing is that there are income limits. The IRS of course has limits around all these different accounts. When it comes to employer retirement accounts, individual retirement accounts, how much can you put in?

And they're also income limits, so you can not contribute to a Roth account, if your income is over a certain level. Okay. And so that's also an important consideration. Now, there is a way of doing it. It's called a backdoor Roth option where you can put it in traditional converted over to a Roth. And so again, if you're in mid-career and you find yourself, Hey, a family of two, both working, you might be above that income limit.

And so that's another reason you might not have much in the tax free bucket. But there are planning opportunities and strategies for trying to get more money into that tax-free bucket.

Matt: [00:14:41] Can you say a little bit more about the Roth conversion? What's that all about? 

Mike: [00:14:45] All right. Yeah. The Roth conversion is a way of moving money from your traditional account.

Over to your Roth account. Now the IRS has allowed this. You can move money just like you would move it from your checking to your savings account. You just go to the dropdown. I want to move $5,000. You can actually move money from your traditional individual retirement account to your Roth individual retirement account.

You go into your brokerage or wherever they are. You go in the dropdown. I want to move $10,000 from one to the other and you just do it now. Here's the catch of course. Remember in the traditional, we have not paid taxes on that money as tax. differred haven't paid it yet. If I move it to the Roth, that is all money that has paid taxes.

Okay. So when we move it from the traditional to the Roth we're going to have to pay taxes. So we pay taxes on that money and that's how it works. So you move over $10,000. You're going to pay taxes on $10,000 in the year that you do that conversion. And there's some details of course, on that, but a high level, you're going to pay taxes on that.

And this is again, another strategy  for deciding when you want to have income. Okay. Because if you've built up money in a traditional IRA, you can decide when to move it over to the Roth. And in that calendar year, you have that extra 10,000 of income you're going to pay taxes on. So when do you think might be a good time to do that?

Matt: [00:16:04] I would guess let's say I've had a really good year and it's this is a good time to rip off the bandaid and pay those taxes. Cause I've got the, I've got the available cash. Is that right? 

Mike: [00:16:17] It's the exact opposite, Matt. Dang it. It's trying to trick you there. If you have a good year, you're in a high income tax bracket, so you don't want more income in that year.

So we want to do this during times when you have low income, again, pay your taxes when you're in the lowest tax bracket. And so if you have a year where you're transitioning jobs and you maybe take six months off or you want to travel for a while and you take some time off, these are opportunities where you have lower income during one year.

To pay taxes on money. So you pull your income, you do a Roth conversion. So in that year, you maybe normally make 150,000. You take a bunch of time off and you're making 50,000 here and there. And using some of your savings your tax bracket just went way down. So you could convert a 50,000 and instead of 50,000 of income in that year, you have a hundred thousand.

So you pay taxes on that 50,000 converted. And that's it's, you're paying lower taxes during that year. And the other strategy you could do gifting to offset stuff. , in your case, you have a good year, maybe you get to get some extra money, somehow like an inheritance or something like that, where you're not paying taxes and you want to gift a bunch of money to an organization you believe in that, of course reduces your income by doing a gift.

And so you could again, pair that with a Roth conversion to pay lower taxes. 

Matt: [00:17:35] Oh, I see. So in general, I'm actually finding this to be a really helpful rule of thumb Roth. Think young, basically like lower income younger earlier in career, bad year. Think Roth, take the tax it whenever you're paying at a lower rate.

Mike: [00:17:55] Yeah, that's exactly right now. The other, the flip side is, again, I mentioned a lot of people find themselves with a large traditional account, either 401k or a traditional IRA or a rollover IRA, all traditional again, traditional means that you haven't paid taxes on it yet. A lot of people find themselves having built that up.

And so in early retirement years is another opportunity for doing these Roth conversions. It's anytime you're in a low income tax bracket, you have low income that's when you want to consider contributing to a Roth or doing a conversion. So there are a lot of people out there just about to retire that have built up one or $2 million within their traditional accounts.

Usually a 401k, just been working for a couple of decades, as you said, it's no longer the pension build that up. So now you've got one or $2 million, all tax deferred. And if you have a couple of years where you can live off a taxable savings accounts, you can convert large chunks of that money at a, 15, 20% tax bracket which is lower than when you were working.

Matt: [00:18:55] All right. So we've done the one Oh one here real fast. I want to maybe raise this. It at the end here too, like a two Oh one level. I've heard this term backdoor Roth. Can you give me the lowdown on that? Just to high level,

Mike: [00:19:09] super quick. It is when your income is too high, that you can not contribute directly to a Roth.

You can contribute to a traditional. IRA account, but you cannot defer the taxes. So you put in your 6,000 and you have to pay the taxes on that 6,000. So you have already paid the taxes on that 6,000. You can convert it over to a Roth since you have already paid taxes on it. You do not owe more taxes. We only pay them once and you get money into that Roth account.

So that's the backdoor strategy and it is fantastic, but there are gotchas. If you already have traditional IRAs or rollover IRAs. It gets a lot more complicated, but that's at the high level how to do that. 

Matt: [00:19:51] Got it. Wow. There is a lot to think about and unpack in all this look I, any last thoughts and any take homes for people in just a minute or so we have left.

Mike: [00:20:02] Yeah, the big take home pay taxes when your tax bracket is low. The other thing I like to mention always is that we are in historically low tax brackets. It may not feel that way to you, but you can pull up charts on the internet of what taxes used to be, and they're historically low. So keep that in mind, as we're trying to predict the future as well.

Matt: [00:20:20] Got it. I this is an immensely complicated topic and I think we should note for our listeners that as always, Mike is clearly a deep expert in all of these topics, but you're not providing any direct financial advice. If people need advice on their individual financial planning, their individual financial situation, they should seek out someone to provide them that advice.

But this is good general guidance. 

Mike: [00:20:46] Absolutely always find the experts when you're looking for a particular advice. 

Matt: [00:20:51] Look, bottom line is all of these considerations, Roth, traditional, et cetera, and backdoor a lay up  these are good problems to have, right? Yeah. That's exactly 

Mike: [00:21:02] right. If you're worried about these little details, look, you've already won the game.

You're saving a lot within your employer accounts, your individual accounts, and that's fantastic. And this is just icing on the cake. 

Matt: [00:21:12] Mike Morton of Morton financial advice here on real financial planning broadcast at WK XL thanks again for all of the fantastic advice 

Mike: [00:21:22] Thanks Matt.