What’s a Traditional IRA?
Thanks for coming back for the latest edition of Planning for your Purpose, Telos Financial’s blog, where I discuss different topics related to financial planning. CERTIFIED FINANCIAL PLANNER™ professional Dennis LaVoy is Plymouth, Michigan’s financial advisor serving clients throughout the mitten as well as across the country.
The primary purpose of the blog is to introduce financial planning concepts and questions I receive from clients that I believe are important. I want to start discussions that will educate, benefit, and improve your financial life, ultimately, to help you focus on your telos!
Traditional IRAs are typically what people mean when they just say IRA. IRA is short for Individual Retirement Account and traditional denotes that it is not a Roth account, it’s the OG. While I’ve written about my love for Roth accounts in several pieces in the past, traditional accounts have great benefits too.
So, what is a Traditional IRA?
In short, when you save to a Traditional IRA, you do not pay any income tax in the tax year you make the contribution, but you pay ordinary income tax based on your income in the year you make a withdrawal (as long as you take qualified withdrawals). You still have to pay FICA tax and social security taxes at the time you earn the money, but you save on federal and state income taxes.
To help clarify, let’s compare to a Roth type account (Roth IRA or Roth 401k for example). In the Traditional account, you do not pay income tax today, the year you earn the income, where in a Roth you do. In the future, when you make a withdrawal from a Roth, you don’t pay income tax on the withdrawal at all where in a Traditional, the entire withdrawal is taxable as ordinary income. But, year over year, you do not have to pay any taxes as the account grows.
How’s it compare to a Roth?
Let’s say you earn $2,000 and save $1,000 to a Roth and $1,000 to a Traditional. We’ll assume you pay 20% in taxes and can earn an annual average return of 7.2%. The $1,000 to the Roth has to have the income taxes paid before the savings go in, so you invest a net of $800. Let’s assume both accounts grow for 20 years before you take a withdrawal. Both accounts would have doubled twice in that time, so the Roth IRA would now be worth $3,200 and the Traditional IRA would be worth $4,000.
On the face, the Traditional seems like such a better idea, right? It’s worth $800 more in this example. But don’t forget to consider the tax status of these accounts, one is full of pretax dollars and one is tax free. That $4,000 Traditional IRA money is pre tax. When you withdraw it, will have to pay 20% income tax, so it’s really only worth $3,200 after you pay the taxes. They are net equal in this example.
Compare the taxes paid, in both cases you invested $1,000. For the Roth, you paid a total of $200 in income taxes. In the Traditional, because you’re paying taxes on a larger amount, you are paying a total of $800 in tax, that’s four times the taxes you have to pay!
Now, there’s nothing wrong with paying taxes. Taxes pay for a lot of great things, but if one of your goals is to minimize taxes, this is something to consider.
So, Dennis, if the accounts are worth the same net of tax, who cares where I save?
Well, I care of course and I spend a lot of time discussing this with my clients. I’ve mentioned In previous blogs that Roth IRAs are indeed my favorite account type. There are situations where Traditional IRAs may have a bigger benefit. One of the strongest cases for saving to a Traditional account is when you KNOW that taxes in the year earned are higher than they will be in future years.
In the examples I laid out earlier, imagine if the tax rate was 40%. That would make the net savings between the Traditional versus Roth is now 40%. So, $10,000 invested in the Traditional is only worth $6,000 net in a Roth Account. If in retirement, you expect tax rates to be 20% because taxable income will be lower, now the traditional is worth more. Let’s assume the 7.2% growth rate and 20 years growth. The traditional account value would be $40,000 and the Roth would be $24,000 (40% less, since that’s what the tax rate at the time of savings was). Now, when you need to withdraw from these accounts, the Traditional is pretax, but in this example the tax rate is lower than at the time you earned the money, so net of tax value of the Traditional account is $32,000.
It’s a pretty strong case for saving to a Traditional versus a Roth account, but these assumptions have to be true. If you’re a high income earner, this is something to be aware of.
One of the less appreciated areas of financial planning is tax planning. Forecasting income in retirement, being aware of current effective tax rates, and making expectations of taxes in the future are all important parts of financial planning.
Tax location and tax management are two of the most effective tools in financial planning. If you’d like help deciding what’s most appropriate for you, contact CERTIFIED FINANCIAL PLANNER™ professional Dennis LaVoy today for a free consultation. If you are a DIYer, make sure you spend the time to understand tax ramifications and planning to optimize your savings for your income and financial goals.
If you’d like to discuss your financial situation and if a Traditional IRA, 401k, 403b, Roth IRA, Roth 401k, Roth 403b is right for you, Telos Financial welcomes the opportunity to talk with you. Contact us today to schedule a free introductory meeting and we can talk more in person. Telos is a financial planning firm serving Michigan’s high income and high net worth millennials, recent college graduates, and small business owners.
Telos Financial is a fee based, holistic financial planning firm located in Plymouth, Michigan serving young professionals and their families. Dennis LaVoy is a Certified Financial Planner® Designee and a Chartered Life Underwriter®. Dennis is proud to be a firm based in Michigan focused on serving high net worth and high income young professionals, millennials, and those preparing for retirement. He founded Telos Financial to provide fiduciary financial services to families across Michigan including Plymouth, Canton, Ann Arbor, Detroit, and as well as all over the great United States of America.