Some people have a lot of enthusiasm for Roth IRA / 401k accounts. I understand that its nice to be able to pull tax free money but I don't entirely understand when it makes sense to contribute to a Roth.
First, it absolutely makes sense when the non Roth account isn't available to you for whatever reason. Lets set that aside.
The majority of people aren't able to max out their tax advantaged accounts – should they really turn down a tax deduction today in favor of better tax treatment down the road?
People who are able to max out tax advantaged accounts are doing so during their peak earning years. They are likely to be paying a higher marginal tax rate now compared to in retirement. Does it really make sense to pay higher taxes now?
I read that its a good idea to be diversified between Roth and non Roth accounts – generally speaking I like diversification but this does seem to come at a cost.
As best I can tell Roth makes the most sense when you'll be paying higher taxes in retirement but that strikes me as pretty rare.
So – when should one put money into a Roth over a traditional 401k or IRA?
Help me understand when Roth contributions make sense, strategies for using Roth over traditional
byu/mattkime inpersonalfinance
Posted by mattkime
14 Comments
https://www.reddit.com/r/personalfinance/comments/10qwnrx/why_you_should_almost_never_contribute_to_a_roth/
>As best I can tell Roth makes the most sense when you’ll be paying higher taxes in retirement but that strikes me as pretty rare.
Nail on the head.
Trad > Roth > Taxable for the average Joe.
Do you expect to withdraw more in retirement than you do today? That’s the meat of the question.
I anticipate doing so (inflation) and I can’t imagine America doesn’t raise taxes to address an ever growing deficit (Trump has already raised taxes with the BBB, what’s to say it doesn’t happen again). I’m not 100% Roth but I am split between the two.
You’re never required to withdraw from a Roth 401k with RMDs like you are with a 401k – and when you do, they don’t count as income. I plan on using my Roth 401k to lower my amount of taxable income to a level where I can qualify for low income benefits/not get priced out of other tax credits/Medicare/Medicaid.
You put $100 in today, it grows to $10,000 – you pay $2200 in taxes and leaving you with $7800.
I put $78 in today having paid $22 in taxes, it grows to $7800. We end about the same place, I have paid much less overall in taxes and can count my income as 0 in retirement. You would have to count your income as 10k and potentially lose low income benefits.
I think when starting out and you are in lower tax brackets put it in Roth. Later in career put it in Traditional. By having both you have more options to play with to reduce tax risk in retirement.
When your marginal taxes at withdrawal are projected at a higher rate than marginal taxes at contribution. So, a teenager getting in the habit of saving 5%. Someone in their early career. Someone who things taxes are going to increase due to politics, etc. Someone with a whole lot of deductions now resulting in a temporarily low marginal tax rate. These people would tend to prefer a Roth. In the meat of your career, traditional is probably better. You might still diversify due to the unknown – you don’t know that taxes won’t rise in the future or that you won’t have a very robust retirement, etc.
When you want to manipulate your modified adjustable gross income (MAGI) to meet your financial needs in early retirement while staying in the aca subsidy bracket
For most people with “regular” retirement income streams, you want to take advantage of the tax deductibility of a traditional 401k now at your marginal tax rate and defer your taxes until retirement when you’ll have less income and pay at a lower effective tax rate.
Roth IRA often makes more sense than a traditional IRA because you can lose tax deductibility with the latter so the former is often the only tax-advantaged IRA you have. And you need to also account for backdoor Roth IRA complications.
It can make sense if you expect to have a pension, business, rental, consulting or other income in retirement that will “fill up” the lower tax brackets.
Or you may want to take one or more large disbursements that would be taxed at a higher rate. Imagine someone who only needs $50k/year in retirement income but may want to withdraw $50-100k at once to help their grandkid buy a house, pay for their wedding, go on an epic family trip, buy a boat or cabin, etc.
Usually young people just starting out are earning much less than their later earning potential and often less than they’ll want in retirement.
If you’re having a down income year — maybe you or your spouse is temporarily a SAH parent, or you took a sabbatical, or for whatever reason your income is just lower this year than usual.
If you expect to have significant non-savings income sources in retirement (rental or business income, pension).
If you expect to have enough saved that RMDs will force you into much higher tax brackets.
Qualifying for ACA plans is a big concern for many folks who plan to retire before age 65. Traditional withdrawals may be *tax* efficient, but there is a huge cliff for qualifying for subsidized plans, and Roth withdrawals don’t count as income.
Maybe your 401k plan is so bad that contributing above the match is not worth it, and you make too much to qualify for a traditional IRA deduction.
Well for my friends that are already retired… who I think we should listen to… the reason why they are happy with Roth is because every penny you take from 401k and your other investments increase your taxable income and therefore increases your rates for things like Medicare.
There’s another Roth scenario for high earning people, who are able to max out tax-advantaged 401K, have a lot left over, and would like to invest additional money.
Some benefit plans offer a “Mega back door Roth” that allows for after-tax 401K contributions that are then converted into a Roth account. The contribution limits are pretty high. Total amount (401K + employer match if any + Roth conversion) that can be invested this way is $72,500 for people 50 and under with additional catch-up for older people. More here: [https://www.fidelity.com/learning-center/personal-finance/mega-backdoor-roth](https://www.fidelity.com/learning-center/personal-finance/mega-backdoor-roth)
It’s unlikely in this case that marginal tax rates will be higher in retirement than when the contributions are made. That said, it’s attractive in that allows the benefits attached to Roth accounts. No taxes on capital gains; flexibility about withdrawing deposit money. Also for estate planning purposes, beneficiaries don’t need to pay taxes on inherited Roth dollars (though they need to empty the account within ten years of receiving it.)
I use my Roth IRA primarily as a way to diversify my emergency fund. My dividends/interest earned is tax free.
If you are in the 12% or less bracket you almost always want to do Roth.
If you are 22%/24% and expect to stay 22/24% for your career then you want enough trad to get to the end of the 12% bracket in retirement (don’t forget to include any taxable brokerage dividends/interest and SS as they take up room in those first two brackets and std ded). You don’t want to be breaking even bc of IRMAA, RMDs, inheritence etc. You just want to get that arbitrage between 0/10/12% and your 22/24%. Once your predicted trad balance (plus employer match if you got it) is enough to satisfy that requirement you go to all Roth.
Where you think taxes will be can affect your decision, for instance it wouldn’t be super unreasonable to get your Roth in first before trad bc of how we are at historic low rates but if you mess up and don’t get enough trad in at the tail end of working then you left arbitrage on the table.
It’s more complicated if you are 22/24 now but your career is common to advance to 32%+. Then how long it takes you to get there, your savings rate etc all matters but you should probably do Roth in most cases until you hit that 32%+ brackets.
On benefit of a Roth that’s often overlooked is ACA subsidies for those retiring before 65 when Medicare kicks in.
Roth income adds significant flexibility for gaming one’s income during this time period and could potentially save $20,000 or $30,000/year in terms of premiums and out-of-pocket medical expenses.
Roth IRA is all about taxes.
If your income tax bracket is 12% or less, you do a Roth IRA. Pay those low taxes today, because when you retire you will probably be in the 22% or 24% tax brackets.
If your income tax bracket is 32%, 35%, or 37%, you should probably be doing back door Roth Conversions because chances are very good you will remain in the 32% or higher tax brackets.
The 22% and 24% are the grey areas. I can show you math that doing a traditional is way better because you take the deductions today, and put that tax deferred money growing and compounding. You will have more money and even after paying taxes on distributions for the same amount you withdraw from your tax free Roth, your money lasts one to two years longer.
Some people just despise paying taxes no matter what, the Roth is fine for them.