To Roth or Not To Roth with Michael Kitces
I have been working as a financial planner for over 10 years now and while my clients are all unique with different life goals, a common question that comes up repeatedly is how to best save for retirement, specifically, should you utilize a traditional IRA or 401k plan, otherwise known and the pre-tax options or utilize a Roth IRA or Roth 401k plan or the post-tax options. This question has become increasingly important given that the Roth options have appeared in recent legislative bills, so I thought I would bring on the show a good friend of mine and an expert in helping plan for retirement, Michael Kitces. Michael is the Chief Financial Planning Nerd of Kitces.com, which teaches and trains financial advisors, he’s Head of Planning Strategy for Buckingham Wealth Partners, which provides wealth management to retirees. And Co-Founder of XY Planning Network, a network of 1,500+ fee-only financial planners who provide advice to consumers in their 30s, 40s, and 50s. Michael joins me today to help answer the question, to Roth or not to Roth.
What are we drinking?
Michael - Coffee
Shannon - Black Cherry Schweppes
Podcast Notes
MICHAEL’S ORIGIN STORY
He went to a liberal arts college and studied psychology, theatre, and pre-med. What he learned while in school is that he wanted to do none of those things professionally.
Through a family connection, he interviewed for a job that he thought was financial planning but was actually selling life insurance. He started working this job days after graduating college. This was in 2000, right around the time of the tech bubble.
He tells us that he was mediocre at selling life insurance and a terrible prospector. Having to find people to sell to was horrible and not what he wanted to do.
There were a few salespeople at this job who did give advice and that aspect is what was interesting to Michael. He went nerd deep into the world of financial advice, getting various degrees and certifications along the way, and he’s been here ever since.
The financial product industry has an incentive to make the lines between selling and advice blurry. He aims to make that line very clear and provide tools for folks who give great advice. They achieve this by teaching, training, and elevating advisors who give advice to clients.
THINGS MOVE SLOWLY IN THE FINANCIAL SERVICES WORLD
Shannon started in the finance world around the same time as Michael. They talk about how little has changed in the last 20+ years. The trading floor Shannon started on looks exactly the same today.
There are both benefits and drawbacks to this. Security is incredibly important, which is part of why things move as slowly as they do. It does mean that making changes for the better can take a long time.
TO ROTH OR NOT TO ROTH
The choice shouldn’t be between Roth or not, but rather, Roth vs. traditional.
There are misconceptions around Roth IRAs. How can ‘ tax-free’ not be the best option all the time?
Tax planning can be a tool in your long-term wealth-building strategy.
When Roth accounts first originated, they were more limited, but now there’s more analysis to be done when deciding your retirement vehicles.
One of the best ways to build wealth is by paying taxes when your rate is the lowest.
ROTH VS. TRADITIONAL
When thinking about retirement plans in general, at the end of the day, you will have to pay taxes on that money. It just depends on whether you are paying Uncle Sam before you contribute or when you withdraw the money later.
With a Traditional IRA, you get the tax deduction upfront and pay later, when the money is distributed. With a Roth, you pay taxes upfront, but the money withdrawn is tax-free because you already paid taxes before the money was contributed.
There are a lot of benefits to a traditional retirement account, including the tax deduction you get to take now. Especially if you are in your peak earning years.
If you are just starting out in your career and think your income will significantly increase in the future, the Roth option is perfect for you. This is because your tax rate will be lower now than in later years when the income level (and tax bracket) goes up.
It’s about knowing where you are now and thinking about your future projections. It’s all about timing, what will be the better tax deal? Paying taxes now or later?
If you’re sitting at a middle tax bracket now and are projected to stay around the same rate for your career, mathematically, you can go either way. Or splitting between the two.
We’ve all got personal wealth-building journeys, as income rises, you enter into higher tax brackets. As life and income change, it’s important to get tactical with your plan.
We have a lot of tools in the toolbox to play the timing game. The Roth option doesn’t automatically win.
This should be part of your annual financial planning because the optimal choice can change year to year.
What about Roth 401k and 403b accounts?
HOW THE SAUSAGE GETS MADE
Michael is a native of Washington and loves reading new tax legislation when it is released. He loves talking about how these things work.
Roth IRAs had income limits, so why did congress roll out Roth 401k options?
It brings in more money for congress.They did the math and congress figured out that high-income earners contributing to traditional plans, taking the deduction, may be taxed at a lower rate when distributions are taken later.
Long story short: these are a revenue-raiser for the government. It’s a bad deal for certain high-income earners and a good deal for the federal government. It was added to offset another spending provision.
WHAT IS THE BACKDOOR ROTH AND IS IT GOING AWAY?
If you are saving into a Traditional IRA, you can roll that money over into a Roth IRA. When this happens, the money is reported as income on your tax return but grows tax-free from there.
When you make the conversion, it does not have to be the full balance. Not everyone knows this.
Utilizing this strategy has to be done with balance in mind. It is possible to convert too much and end up with unexpected tax bills, especially if you’re on the line between tax brackets.
These can be an incredibly targeted tool, helping folks fill out lower tax brackets in years when it is advantageous to do so. If you have a lower income year than usual, that’s a great time to take advantage of a conversion.
The ultimate goal should not be ‘have a $0 tax bill in retirement’ It’s about looking at tax rates for when the money is withdrawn in the future and recalibrating the mechanism along the way.
CHANGES TO THE BACKDOOR ROTH CONTRIBUTIONS
The proposed changes in the rules aim to limit high income earners from using Roth accounts. It’s been on and off the plate in Congress with the Build Back Better bill. There are two proposed changes and we are waiting to see what makes it to the final bill.
The first provision is an outright prohibition on Roth conversions of after tax dollars in your retirement account. This will affect high-income earners and participate in your workplace retirement plan. People who utilize these conversions are usually better off contributing to a Traditional IRA.
The second has much less impact. It puts a cap on these conversions for folks at a certain income level ($400,000 for single folks, $450,000 for married filers) . It would go into effect in 2032. This delay is because of the 10 year revenue projections and it is expected to make the government a lot of money around 2030 as people try to do these conversions before they are capped.
The provisions may never appear, or can appear three minutes before legislation passes because it was the perfect line item to make the budget work. Things are always moving and changing when it comes to tax laws.
Takeaway: My biggest takeaway is that understanding and contemplating current and future tax rates is not only a good financial planning strategy but it can also save you thousands of dollars along the way which can help you achieve your retirement goal sooner than later.
Random Three Questions
If you did not work in financial planning, what would you be doing?
What is something you love to binge?
If this was your last meal on earth, what would it be?
Connect with Michael
On Twitter: @mikekitces
On Facebook: Michael Kitces
On LinkedIn: Michael Kitces
On Youtube: Michael Kitces
If you have any topics you would like for me to cover on this podcast or you’d like to get in the financially naked hotseat, I encourage you to email me to shannon@fingyms.com or join the private Martinis and Your Money Facebook Group and let me know what you want to hear.
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