Roth vs. Pre-Tax: Tax-Free Growth Explained

Investing in Roth vs. pre-tax accounts depends on tax rates and future income, with Roth being advantageous for lower brackets.

### Understanding Roth IRA: Tax-Free Growth Explained
* 💰  Roth IRA offers tax-free growth because contributions are made with **after-tax dollars**, and qualified withdrawals are **not subject to taxes**.
* 📊  In practice, many retirees are in a **lower tax bracket** than during their working years, making Roth more advantageous for **long-term growth**.
* 🧒  For young investors like Benjamin, starting with a Roth IRA while in a **low tax bracket** can maximize **tax-free compounding growth**.
* 📈 " The thought is that when you retire, you'll hopefully be in a **lower tax bracket**, so you'll be able to take advantage of the **difference**.
* 🔄  Tax rates are not static, so it's important to consider **current and potential future tax brackets** when choosing between Roth and traditional pre-tax accounts.
* 🔒 " When you get to step six [of the financial order of operations] and you're getting into higher tax situations, you'll probably want to do the **pre-tax**.
* 🏦 " But while somebody your age, I would assume while you're in one of those lower tax rates of **12% or 22%**, let's get that money in there.
* 🎓 " Yes, you're paying taxes on what you earn to fund that account, but you're in some of those lower tax rates from a historical standpoint. You're going to **max out that compounding growth at a tax-free level**.

[Music] Benjamin's question is up next. He says, I'm 33, but talk to me like I'm a third grader. That made me laugh, but he says, I don't understand how Roth is tax-free growth. If I invest 15% pre-tax, wouldn't the amount I would pay in taxes give me extra compounding growth? Yeah, so this is a really interesting thing. And if you spend a lot of time with financial calculators, people are amazed to find this out. In a vacuum, if tax rates are the exactly same, the mathematics work out to where pre-tax and Roth are equivalent, right? So if what you said is true, if I have more money going into a pre-tax account and that money grows and then I pull it out at the same tax rate that I would have been in when I put it in, the mathematics are going to work out the same whether it's pre-taxed or Roth. What actually happens though for most folks, at least in practice, in the business

that we're in, you know, we're F only financial advisor, so most of our folks, when they get into retirement, they're in a lower tax bracket than they were in their accumulating years. So when they put money in pre-tax, they get a 30% tax deduction, and when they go to pull that out in retirement, their tax bracket might be 12% or something along those lines. And so, in that scenario, it was more advantageous for you to get the tax benefit today instead of waiting to have to pay a lower tax rate later. If you can do that, then Roth is more advantageous. The reason that it's tax-free is that you pay tax on the front. In both accounts, pre-tax and Roth grow tax-deferred, and then assuming that certain qualifications are met, like the account was open for 5 years, you're at least 59 and a half, then you get to pull out all the money you put in, which has already been taxed, plus all the earnings completely tax-free and penalty-free. It's really an Arbitrage on your tax man, you know.

what is not a good idea he said explain it to me like a third grader and I just said the word arbitrage that's not a good that's not third I'll bring it this is what you say to me to to bring in the third grade stuff cuz I already naturally talk like if you read my book millionaire Mission a lot of you I think you're giving me a compliment you said this is perfect all you have to do is like read at the the an eighth grade level and I think you'll understand these Concepts and I'm like I think that was a compliment so I'll bring it home for you Benjamin is that the the the issue is and Boose said this tax rates aren't static and that's why um for most people you're 33 which I still consider young because I'm in my 50s now um you're not in your highest earning potential Years yet you know so typically in your 20s you come out and you're broke you're not making a ton of

money um but so your tax rates are super low. Think about it. I mean, we have uh 12% tax rates. We have 22% tax rates. These are all pretty pretty low from a historical perspective. It makes sense to. Yes, you're you're paying taxes on your income, but the after-tax money then gets contributed into a WTH, and then the growth is tax-free. The thought is is that when you retire, um, you you'll hopefully because all those years that that money is growing, you're hoping that that you'll be able to potentially take advantage of the the difference. And that's why I'm trying to avoid the Arbitrage is such a good word one. So, but Benjamin, when you get to the point, this is why in the financial order of operations, notice I don't know why I have the signed one here. It seems a little self self flating, but we focus on the WTH first CU you're in those lower income tax situations, but then when you get to step six, you're getting into

higher tax situations likely you have to make that decision is my tax rate my my effective my marginal rates if you add my federal and your state. That doesn't sound like a third-grade word either but your tax rates. If they're over 30%, you'll probably want to do the pre-ex so you can do exactly what you're talking about, take advantage of the tax savings to grow the money, and then hope when you retire you're in a lower tax situation. Then you can potentially convert to Roth at that point. But while somebody your age, I would assume while you're in one of those lower tax rates of 12% or 22%, let's get that money in there. Yes, you're paying taxes on what you earn to fund that account, but you're in some of those lower tax rates from a historical standpoint. You're going to max out that compounding growth at a tax-free level. And then as your income goes up, you'll probably need to change into more traditional pre-tax. But while

you're young. Take advantage of that tax-free growth opportunity. I love it.

How Is Roth Tax-Free Growth? (Explain It to Me Like I’m in 3rd Grade)

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Understanding the Tax-Free Growth of Roth Investments

Roth and pre-tax investments can be equivalent in a vacuum with the same tax rates for contribution and withdrawal.

However, in practice, most people are in a lower tax bracket in retirement, making Roth more advantageous.

Roth investments provide tax-free growth and allow for tax-free and penalty-free withdrawal of contributions and earnings under certain qualifications, serving as an arbitrage on the tax system.

The Problem with Arbitrage in Simple Terms

Explaining arbitrage to a third-grader is not a good idea, as it is a complex financial concept.

The strategy involves taking advantage of tax rate differences, focusing on investing in a WTH in low-income tax situations to benefit from tax-free growth.

This is part of a financial plan outlined in the "financial order of operations," emphasizing the importance of timing in maximizing financial opportunities.

Making the Right Tax Decisions for Your Income

Considering both federal and state tax rates is crucial in making the decision to contribute to a pre-tax account.

If your combined tax rates are over 30%, taking advantage of tax savings and planning to convert to a Roth account in a lower tax situation may be beneficial.

For individuals in lower tax brackets, contributing to a pre-tax account can maximize compounding growth at a tax-free level, especially when in the 12% or 22% tax rates.

As income increases, transitioning to a more traditional pre-tax approach may be necessary.

Embracing Tax-Free Growth Opportunities at a Young Age

Take advantage of the opportunity for tax-free growth while you're young to maximize your investment.

This strategy allows you to benefit from compounding interest over time without being taxed.

Start early to make the most of this financial advantage and secure your future.