As you plan for retirement, you need to decide if you want your
money in pre tax accounts or in after tax Roth type accounts.
And you can use brokerage accounts as well, but we're going to stick
to those retirement accounts for right now. So we'll go over the numbers
in a way that is often pretty surprising to people, even very smart
people. It's not that complicated, and we won't bore you to death,
hopefully, but I want to show you something that's often very interesting,
and then we'll get into some surprising issues that can come up as
you make this decision. Not going to spend too much time on the
ins and outs of these accounts or the five year rule or whatever,
but the pre tax account is a way to save money by reducing
your taxable income when you put money in... And by the way,
this discussion can help you whether you are actually saving money each
month, for example, or if you're thinking of doing Roth conversions and
converting a big chunk of money from pre tax to Roth. So those
pre tax accounts have some tax benefit upfront, but you do eventually need
to pay income tax when you take withdrawals and start using that money.
The Roth accounts, of course, can potentially provide tax free income in
retirement, so that would help you avoid having to pay income tax in retirement
and affect some other things that we'll talk about later, but you don't
get a tax break up front, then of course, both types of accounts
offer tax deferral as the money is growing. So, now let's talk about
what would you do with the next $100 of income, and if you
are thinking about converting then we're just going to make the default
assumption that you already put money into pre tax accounts, and so moving
to Roth will be the difference here. Starting with some equal tax rates,
we'll just assume things are the same today and later, so it's 25%
today and later... But I promise you that these numbers and the math
will work the same whether you use different tax rates, or if you
use bigger numbers or more complicated numbers. A lot of times people think
$100 isn't quite right, or 25% isn't perfect, and that's okay,
you can change these numbers. But the math, I promise you,
is going to be the same, so I'm going to get my face
out of the way. We say that you are using a pre tax
account here first, so you've got $100 of income or $100 to do
something with. There are no taxes due on that $100 of income,
if you put it in the pre tax account, so the whole $100
gets invested and then your money doubles over X number of years,
it doesn't matter, you can pick however long you think that takes...
Maybe it's 10 years, 20 years or much faster than that,
but eventually you have $200 because your money doubled, and when you withdraw
the money, you're going to owe 25% taxes or $50
on that, and that leaves you with $150 to spend on things in
retirement: Food and health care and entertainment and travel.
So. We get over to the Roth, we've got your same $100,
and to make it apples to apples, we're going to pay those taxes
out of that same 100, so you only get to invest 75 in
your Roth, but it is the exact same investment mix with the exact
same returns, because you can do that in a Roth versus a pre
tax account. Use the exact same investments, so the money doubles again,
and when you pull it out, you owe no income tax,
we're assuming you've satisfied all of the IRS requirements for that.
So the after tax spending amount is 150,
so in both cases, you have 150 to spend after you pay the
taxes, so you might be tempted to say that I'm indifferent as to
whether or not I choose pre tax or Roth because I have the
same amount after taxes, and that's a reasonable way of looking at it,
but it is a little bit more complicated than that, and we're going to get
into that in a second, but we'll quickly just look at the classic
examples of when pre tax versus Roth makes sense. So if you're in
that lower tax rate today and a higher tax rate later,
then Roth is going to be more advantageous. I'm not going to go
through the numbers, but you've got 180 left to spend versus 150.
And we can flip that around and say, you're in a high tax
rate today. This is the traditional rationale for using the pre tax 401ks
and IRAS, and then a lower tax rate at retirement. In that case,
you would end up with more... Using the pre tax count.
Those numbers we looked at are extremely important, but there are some other
really important factors that are going to help you make this decision,
they're going to affect what's best for you, so one of them is
Social Security. Depending on your income, your Social Security income might
or might not be taxable, and it's taxable at different levels,
but the gist of it is that the lower your income from other
sources such as traditional pre tax IRA withdrawals, the lower your income,
the less likely it is that you're going to pay taxes on your
Social Security income. Healthcare is a similar thing, so your Medicare
premiums or maybe some other factors might come into play with healthcare
costs, again, the lower your income, the better off you're going to be,
and these aren't necessarily taxes, they might be called "hidden taxes"
or unexpected costs in retirement, but it's a big deal, it's money that
you would have to spend, so that's why you want to pay attention
to how high your taxable income is going to be in retirement.
There. Are a number of other factors, different credits or deductions that
you might qualify for if you can get your income low enough,
and those of you who are "supersavers" who really want to max out
those accounts, might also favor Roth type accounts. Now, so far,
I've been talking a lot about how a Roth might be advantageous because
it helps you keep that income relatively low, and that's all true,
but that doesn't mean that Roth is always best or necessarily best,
it can get quite a bit more complicated and we're going to talk
about that in a sec, but the last thing to mention here is
flexibility, so those Roth accounts allow you to take out your own contributions
at any time without taxes and without penalty, so that adds some flexibility.
You can't necessarily get into the earnings on top of the money you
contributed, but taking out your own contributions is often an option if
you need to do so. So let's look at some potential complications here.
It's hard to predict the future, but are tax rates going to be
higher or lower? Because that's what we were looking at on those numbers
slides. So what can make the tax rates rise or fall?
Two things in particular would come to mind. One is your income level,
so the amount of income you have is going to affect the rate
that you pay taxes at, and so the higher your income,
the higher the tax bracket you tend to be in. The other thing
would be tax rate changes, so if the laws change to make the
same amount of income taxed at a higher level, then that's something that
could potentially affect your taxable income and all that other stuff we
were talking about. So we don't know what's going to happen with tax
rate changes. We pay for things out of income taxes for the most
part, and if that revenue generated isn't enough, it is possible that lawmakers
would choose to raise the tax rates. I don't know if that'll happen,
don't know when it will, but it's just a possibility and something to
be aware of if you're thinking of these things.
Finally, we've got an unknown future, it's just really hard to predict the
future, so you might see your situation and say it definitely makes sense
for me to do a Roth. But things could change. So for example,
they could switch to consumption taxes, so you pay taxes on things you
buy instead of just getting taxed on your income like we mostly currently
do. So you pay consumption taxes on sales taxes, like local taxes for
the most part, but what if those become federal type consumption taxes or
value added taxes? Or a flat tax could come into play
any number of things. I don't know how likely they are.
You probably have your own opinions, but the point is that things could
look very different than they do today, so what you need to do
is look at all of these different things and then decide what's right
for you... By the way, I want to ask you to please subscribe
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