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!
Roth IRAs are probably my favorite account type. There are a lot of reasons which I’ll go into below, but if you’re not saving to some type of Roth account, I would strongly encourage you to consider it or talk with your financial professional about starting one.
So, what is a Roth then?
In short, when you save to a Roth you pay income tax today, but (as long as you take qualified withdrawals) any growth in the account will never be taxed.
It might be easiest to try to understand this by comparing to a Traditional IRA. In a Roth, you pay income tax today, but don’t pay tax when you withdraw the funds or on the growth of the account. In a Traditional, you don’t pay income tax when you earn the money today, but when you withdraw the funds, you do pay tax on the full withdrawal (which includes growth), and it’s all taxed as ordinary income.
Why not Traditional?
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 goes 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! Keep in mind the taxability of these accounts. That $4,000 Traditional IRA money is pre tax. When you withdraw it, you still have to pay 20% income tax, so it’s really only worth $3,200 after you pay the taxes.
Compare the taxes paid, in both cases you invested $1,000. For the Roth account, 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. The benefit to the Roth IRA account in retirement is it gives you the power to choose whether or not you pay taxes. No one knows what taxes will be in the future, but you do have to make an assumption for planning purposes. I like to assume taxes will remain around the same level for purposes of financial planning. There are so many factors to consider, guessing what political climate will be in the future is a gamble.
Having the ability to take tax free withdrawals allows you to balance your taxable income with tax free income in order to manage your tax bill. A good strategy for this is to plan your retirement income, review how it will be taxed (federal and state) and calculate how using tax free (Roth IRA or Roth 401k) withdrawals in addition to your taxable income sources (Traditional IRA, 401k, etc) to reduce your effective tax rate and overall tax bill. While you’re working, you have some flexibility on where you save and how much tax you pay. When you’re retired, you are limited by what you have saved, other income sources, and the tax laws at the time. Do you think it makes sense to give yourself more ability to control taxes? I do.
Roth IRAs don’t always make sense of course. If you have a super high income year, saving on taxes today might make more sense for you. If you expect to have very low income needs in retirement, it might make sense to pay the taxes then, if your income is lower, your taxes will probably be lower.
Almost on a daily basis, I’ll have discussions with folks about the different tax ramifications of their savings; whether that means saving to a Roth IRA, Traditional IRA, or other account. It’s really important to understand how your savings benefit you today and, in the future, when you plan to withdraw it. I believe it’s one of the most under appreciated and misunderstood areas of financial planning.
Tax location and tax management are two of the most effective tools in financial planning. Make sure you talk to your CERTIFIED FINANCIAL PLANNER™ professional or tax advisor about this. 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 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 and 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.
Neither FSC Securities, Inc. not its representatives provide tax or legal advice.