Let me share why I never contributed to a Roth IRA, but why you probably should. I fully admit that I was once an ardent opponent of the Roth IRA. But as a middle-aged father of two young children, I’ve come around. Contributing to a Roth IRA is a great way to diversify your retirement income sources.
If I could rewind time to when I was a junior in college, I should have opened up a Roth IRA and started investing. Don’t make my same mistake. Time is the most powerful asset when it comes to investing.
Roth IRA Wisdom From My Father
My dad is in his 70s and he mentioned he wish he’d started a Roth IRA when he was young. When you’re in your 70s, you must take required minimum distributions from your pre-tax retirement savings accounts and pay taxes. Given nobody likes to pay taxes, I empathized with his regret. It’s also a good idea to listen to your elders.
But I don’t have a problem paying taxes on income earned. It’s only when I have to pay a surprise tax where the liability wasn’t properly budgeted where I have a problem. This only happened to me once when the state of California passed a retroactive tax of 2.9% for the 2011 tax year.
I’ve been a long time opponent of contributing to the Roth IRA. However, now that I’m older and wiser, let me share some of my excuses and encourage you to contribute to a Roth IRA if you are eligible.
Why I Never Contributed To A Roth IRA
1) I didn’t have much money left over.
When I first got a job in 1999, I was only making a $40,000 base salary living in Manhattan. $40,000 did not feel like a lot of money back then, especially since I couldn’t even rent a one bedroom apartment on my own. Even splitting a studio apartment for $1,800 total required my brother-in-law to be a lease co-signer. In NYC, you needed to make at least 40X the monthly rent in annual salary, and my roommate and I did not make over $72,000 combined.
After maxing out my 401(k) to the tune of $10,500 and paying taxes, I didn’t have much left. I needed the ~$200 month left in cash flow to pay for incidentals. Something always tends to come up – like actually having some fun once in a while.
2) I didn’t know any better.
Ignorance is a common excuse for why we didn’t do things. However, it is up to use to get smart for our own good. The Roth IRA was introduced in 1997, when I was a junior in college. Saving for retirement was the last thing on my mind at that age. Getting a job was number one!
The 401(k) was easy to contribute to. It was automatically set up with my employer as part of my employee welcome package. All I had to do was fill out a form indicating how much should be deducted from my paycheck and year-end bonus, if any.
With a Roth IRA, I had to open up a new account. This felt like too much of a PITA at the time. When you are already not feeling rich, you don’t normally go out of your way to feel poorer.
Further, there wasn’t a ubiquity of affordable online brokerage options or personal finance blogs to provide any guidance.
3) The contribution limit was disappointingly low.
Even though I only made $40,000 my first year, being able to only contribute $2,000 maximum to a Roth IRA felt underwhelming. At age 22, I would much rather have $2,000 in cash than lock it up for at least five years. The poorer you are, the more valuable each liquid dollar is.
Check out the historical Roth IRA contribution limits. Only in 2019 has the Roth IRA contribution limit grown to a relatively significant amount of $6,000. The 401(k) max of $19,500 versus the Roth IRA contribution max of $6,000 ratio is now only 3.25X. Back in 1999, the ratio was 5.25X ($10,500 / $2,000). Therefore, focusing on the 401(k) was a better choice for me.
For 2021, the Roth IRA maximum contribution remains the same at $6,000.
4) I hated paying taxes.
When you’re struggling to pay for a studio apartment with a friend while also working 70+ hours a week, the last thing you feel like doing is paying more taxes up front, which is what the Roth IRA retirement plan is.
My taxable income was $29,500, which put me at the 28% marginal federal income tax rate at the time ($26,250 – $63,550). Then, of course, I had to pay New York State and City taxes. It felt terrible paying 30% in taxes for a $2,000 Roth IRA contribution. So I didn’t.
The only way I’d feel good paying taxes up front for my Roth IRA contribution is if the effective tax rate was 15% or less. Further, I had to be working a leisurely 40 hours a week or less. Working very long hours makes you really bitter about the tax system.
5) I finally started making too much.
When I got my lucky break and moved to San Francisco for a new job, I was making a base salary of $85,000 and was guaranteed a $50,000 bonus. As a result, my total compensation in 2001 was about $120,000. This was $10,000 over the maximum $110,000 income allowed for an individual to contribute to a Roth IRA at the time.
Although it was nice to earn more money, it also felt disappointing to be shut out based on an arbitrary income limit. Why wasn’t the income limit $150,000 or $200,000? Was the government saying that not everybody deserves to be treated equally when it comes time to save for their future? It felt that way.
In San Francisco, I still lived extremely frugally. I shared an even cheaper apartment ($1,600/month vs. $1,800/month in NYC) for the first two years. The $40,000 a year lifestyle stayed with me for another four years. I still wasn’t sure I’d be able to survive in the finance world for very long. It was only after I finished my MBA in 2006 did I start to spend a little more.
If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $140,000 for the tax year 2021 to contribute to a Roth IRA. If you’re married and file jointly, your MAGI must be under $206,000 for the tax year 2020 and 208,000 for the tax year.
6) I’d be in a lower tax bracket in retirement than while working.
This was the main reason why I thought contributing to a Roth IRA was illogical. Not only did I feel federal income tax rates would come down since 1999 (which proved correct after the TCJA was passed at the end of 2017), I also believed it would be incredibly hard to amass enough capital to reproduce my average W2 income wage.
For argument’s sake, let’s say I made $100,000 in 1999, meaning that I paid a 31% marginal federal income tax rate, or ~25% effective federal tax rate. My $100,000 turns to $75,000. I would need to accumulate $4,000,000 in capital producing a 2.5% gross yield to match my gross working income. I was bullish on my future, but not that bullish.
The people who are angry at my after-tax investment targets for early retirement, yet strongly believe in contributing to a Roth IRA are demonstrating inconsistent logic. If you don’t believe you can accumulate multiple millions, then you should not be contributing to a Roth IRA.
Further, I wanted the option to move to one of our no state income tax states in retirement. By contributing to a Roth IRA while working in one of the highest taxed cities in America felt like I was giving up.
Take Advantage Of The Roth IRA When You Can
After reading all my reasons on why I didn’t contribute to a Roth IRA, I hope you see them just as poor excuses.
Unlike me, be super bullish about your future.
I felt so burnt out after a couple years working post college that I thought I was just going to be a beach bum in Hawaii paying zero income taxes for the rest of my life. My grandfather had an old farmhouse I planned on staying in for free, in exchange for maintaining his mango trees.
Instead, what happened was I had a good 13-year career in finance where I got promoted to Vice President at age 27 and to Executive Director at age 30. After retiring in 2012, I ended up building Financial Samurai into an asset that generates significant supplemental retirement income.
Further, with the massive bull market that ensued in stocks, real estate, and bonds since I started working full-time in 1999, my passive income has also grown significantly. Therefore, I’m once again back at a high federal marginal income tax bracket, which I definitely did not anticipate in “retirement.”
The Roth IRA Is Retirement Diversification
I’ve warmed up to the Roth IRA because it is clearly a way to diversify your retirement savings and income. The maximum contribution has also increased to a not so insignificant $6,000 a year. Meanwhile, the income threshold for contributing has increased to $140,000 and $208,000 for single and joint filers for 2021.
$208,000 is a healthy income for married couples that put them in the top 15% of income earners. Even if you live in an expensive area like San Francisco or New York City, at least one partner should be able to max out their 401(k) and contribute the maximum to a Roth IRA.
Roth IRAs also have no RMDs; they can be assumed by a qualifying spouse upon the owner’s death and rolled directly into the survivor’s account (or a new account in the survivor’s name). They can also be transferred to a designated beneficiary tax free as well, under the same distribution rules as Traditional accounts: lump Sum or 5-year exhaustion.
If I was able to contribute $4,000 on average to a Roth IRA and earn a 9% compound return for 19 years, today I’d have about $200,000 I could withdraw tax-free. Over a 50 year period, my Roth IRA would grow to $3,553,000 with the same terms. That’s not something to sneeze at!
However, if you’re already in a higher tax bracket, then doing a Roth IRA conversion is probably not worth the effort. You likely won’t save tax dollars in retirement if you are above the 24% marginal income tax bracket.
Open A Roth IRA For Your Children
Unfortunately, I’m still not eligible to contribute to a Roth IRA. However, at least I’m able to open up a custodial Roth IRA for each of my two children.
They can earn up to the standard deduction tax-free, contribute to a Roth IRA tax-free, let their money grow tax-free, and withdraw tax-free! I won’t allow them to make the same mistake as their old man.
My hope is to put them to work for our family business. This way, they can earn income, save for retirement, and learn useful skills.
In 15+ years, I hope they will thank me!
Related: I Could Have Been A 401k Millionaire By 40 Had I Kept My Job
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Readers, who is contributing to a Roth IRA and how’s that going? Anybody contribute to a Roth IRA and make more than the income thresholds and have to stop? Is a backdoor or mega backdoor Roth IRA conversion worth it if you are in a high income tax bracket? Anybody now pay more in taxes as a retiree than as a full-time worker? If so, share us your secret to wealth.
Hi Sam,
I’m a recent reader and have loved scouring your posts for the past few weeks; thanks so much!
As an Aerospace Engineer 6 years out of college, I have been investing 16% of my salary into my 401k since I began working (now I will be increasing that to 19k/year per your articles). I have always elected to contribute via Roth 401k. Could you elaborate on if you recommend this vs before tax contributions, and why? (personally I figured I’m making less now than I plan to be making at retirement, hence I’d rather pay my taxes now)
I appreciate the insight,
Jacob
Read through about half the comments and not sure if anyone brought this up:
You make 19,000 a year and your Roth and Traditional 401k contribution limits are 19,000, and you have a 20% tax rate. You live with your parents, all expenses paid.
You also retire in 1 year, your tax rates never change, and your account return is 30%.
With the traditional you put all your income in, make 30% bringing your balance to 24,700, and withdraw, paying your 20% tax rate and ending up with 19,760.
With the Roth you pay your tax and contribute the balance to your account, which is 15,200. You get your 30% return and withdraw, receiving 19,760.
Let’s say instead of making 19,000 you make 30,000. Any non-retirement account money contributes to family expenses.
With the traditional you end up with the same amount, but with the Roth you now have enough money to contribute the maximum of 19,000, rather than only 15,200 before. So now you end up with 19,760 with the traditional, but 24,700 with the Roth.
The secret sauce here is the difference between pre and post tax dollars, which means that with a positive tax rate, equal nominal limits for traditional and Roth make the Roth limit higher in post-tax terms. Even if you invest your tax savings from your traditional contribution, the gains on that investment are taxed, so you will come out better with the Roth, because of the higher contribution limit, post-tax.
If you need the tax saving from the traditional contribution to live on, then this is a moot point, and if your company doesn’t offer a Roth option or the nominal contribution limits are not the same, then it’s also irrelevant. However, if you are saving above your traditional 401k limit and won’t need those finds till retirement, the Roth will always result in a higher return.
Pondering ideas to create a baby roth. I have a 2 year old that I want to open a Roth for but he has to have earned income. In a few years maybe doing household chores will get him some earned income but what can a 2 year old do to have earned income? Modelling for baby products is a possibility. Any ideas from the bright minds here?
Get with a tax professional to identify avenues to invest in a ROTH IRA for your child. Prob best to first have a 529 open and funded monthly prior to the ROTH.
Thank you, I already fund a 529.
This is a little dated, but as someone else said, see a tax professional. Paying your child for household chores and allowance do not count as earned income for kids and can NOT be used to fund an IRA (any type). Modelling for commercials, mowing your neighbors yard, etc, etc, does count though.
I do a backdoor ROTH for me and wife only after maximizing my pre tax accounts. It’s an easy choice for me as the other option would be an after tax investment account. ROTH is excellent for liability protection and as an asset transfer vehicle to your heirs as well.
In fairness to your Dad…he was in his 50’s when the Roth IRA was born. :)
I never agreed with an income restriction on the Roth…with the Backdoor option availble I suppose…although there are tricky pro rata rules tied to that. Lucky for me, my current company allows the elusive in-service/non-hardship withdrawal aka Mega Backdoor Roth option. I feel like I’m making up for lost time. Perhaps your next gig will have the same option, Sam. It’s at a company’s discretion as to whether it’s offered/an option.
Shiver me timbers! I had posted a few times earlier this year expressing my opinion that ROTH contributions are a great benefit for average humans such as my wife and I. I was compelled to post because FS opined that ROTH contributions are not a good idea.
Now, as an early Christmas present, FS has authored a new post promoting the positives of ROTH contributions. I feel like I scored on Jordan (23 not 45) during his dominant years!
Sam, your posts are often thought provoking, as well as entertaining. But I am grinning ear to ear reading an article you wrote that supports ROTH contributions.
Our household is now contributing all new money into ROTH 457 contributions at 15% yearly as well as doing large pretax to ROTH conversions each year without pushing us into a new tax bracket. Our goal is to convert at least 50% to ROTH from our pretax accounts.
2019 ROTH 457 limits are 19,000 yearly, which is huuuuuuge in my feeble mind.
The rest of our plan is:
1. Paying off the mortgage off way early. Currently debt free other than mortgage.
2. Contributing to post tax investment and high yield savings accounts as Sam has discussed.
3. Maxing HSA accounts.
4. 12,000 – 14,000 yearly into 529 plans for our 2 small humans.
We had never even thought of doing post tax investment accounts until FS wrote his article discussing that subject matter.
While funneling pretty decent sums of US currency into ROTH accounts, I figure we are tricking ourselves into investing more. We are putting the same amount into ROTHS as we were in pretax. We felt the pain initially then we did not recognize the difference.
Keep up the fine work Sam! It is a little present to unwrap and read each week.
Be well and Happy Holidays!
Great stuff! And on behalf of the government, I want to thank you for your tax contribution.
Every Roth IRA contributor plans to be a multi-millionaire, which is why they are paying tax upfront because they fear they will make much more in retirement and therefore pay higher taxes.
To have such confidence in one’s financial future is a great thing. How can one not be bullish for our kids?
Let’s just hope the stock market and real estate market don’t collapse too badly, otherwise, the DIRE Movement might really take off!
Cheers
Haha, while we all have plans to be a multi-millionaire, the sad truth is very few of us will ever get there. That’s why I 100% agree with you that for most people, the traditional 401k is better. When I say multi-millionaire, I’m also throwing an additional caveat on that, meaning that it is adjusted for inflation. You may have $2 million 40 years from now, but after 2% inflation over that same 40 years that $2 million is worth less than $900k in present terms money. People need to understand the full picture.
Unfortunately most of the people commenting here are just regurgitating information that they’ve read on the web somewhere. Most people are not good enough with excel equations to run the numbers for their own personal situation.
For me, I’m retiring once I hit 100% income replacement. Which the vast majority of people will never be able to achieve. And for me, I’ve ran the numbers multiple times (ROTH vs Traditional) and I am investing 100% in a traditional 401k. Why would I want to pay taxes at my highest marginal rate right now, versus a lower effective rate later on? That just doesn’t make sense!
I do love your comment for anyone contributing to a ROTH!
On behalf of the government, I want to thank you for your tax contribution.
I do feel like the ROTH was set up by the government to fleece the general public out of more and higher taxes right now. The reality is that very few of us fit a situation where a ROTH makes sense. However the government tries to blanket promote it like it’s the best thing ever because they know it’s a money maker for the government, not for the public.
Sam,
I have long been a proponent of the Roth savings options for a number of reasons covered in your article. Additionally, being an avid saver and religiously maxing out my tax advantaged retirement accounts, I’ve seen the roth as an avenue to maximize the tax advantaged benefits (i.e. the maximum contribution for a roth is ~1.25x that of a pre-tax account, in pre-tax dollars). Given that I’m 30 years old, I’ve “grown up” in an environment with much higher roth contribution limits than most. This is evident by my current wealth allocation as outlined below (rounded directionally for simplicity):
Roth Accounts – Post Tax: $250K (42%)
Brokerage Accts. – Post Tax: $300K (50%)
Trad. IRAs / HSAs – Pre Tax: $ 50K (8%)
To the “tax diversification” point in the article, I’m concerned that I am over-indexed in post-tax savings. My question to you… what is your recommended mix of pre and post tax retirement savings? Should I be pivoting my retirement efforts towards traditional accounts?
Set your solo 401k to allow mega-backdoor Roth contributions, Sam.
Taxes will go up, making tax free withdrawals later critical.
The ROTH is a wonderful way to leave dollars to heirs.
You don’t have to reduce net worth for taxes. $1M in a ROTH is really $1M. $1M in a tax deferred account may just be $600K, or less if taxes go up.
While it is not true that taxes WILL go up, the Roth is a nice insurance policy against tax increases. You really do need to consider whether your tax bracket in retirement will be anywhere near where it is during your working years. If you are a high earner, it probably won’t be.
Good Post Sam, I find the american retirement accounts confusing relative to Canadian accounts. Canada launched a Roth IRA look alike in 2009 (TFSA) and i think they built on it to make a better version. It is post tax contributions with tax free growth in perpetuity, you accumulate contribution room if you miss a year of contributions. It is almost fully liquid (can withdraw at any time but cant re-contribute the withdrawal amount in the same year. An it is available for all income levels – which is great. I don’t know that there are really any drawbacks relative to a taxable account.
It is a great place to hold particularly tax inefficient investments, like REITs (taxable as regular income in Canada) and such.
My stepson turns 21 next month. Our gift to him, which I know he definitely won’t appreciate right now, is sitting down with him and walking him through the process of opening a Roth IRA. We will also start it off with a modest amount and commit to matching that amount for the next 3 years (while he’s in college and only working part time). I really hope I can show him how even small amounts invested early in adulthood can make a big difference later.
Just to clear up a rule that I have seen misunderstood by many and in this feed on Required minimum distributions on an inherited non spousal roth:
There are two options: The first is that the beneficiary has to take out the entire balance by December 31st of the year containing the fifth anniversary of the owner’s death. The second is more complex, but potentially much more advantageous. The beneficiary will have to start taking distributions over the beneficiary’s life expectancy, starting no later the December 31st of the year following the year of the owner’s death (this process is called the Term Certain Method).
If distributions to the beneficiary do not start by December 31st following the year of the owner’s death, the rule requiring a complete distribution of the plan balance within five years will become effective. Generally, a written election choosing the Term Certain approach should be filed with the plan administrator as soon as possible.
Beneficiaries would be well-advised to choose the ability to take withdrawals from the inherited Roth IRA over their life expectancy. The funds in the Roth IRA will continue to grow and compound tax-free while still part of the Roth IRA and the distributions from the Roth IRA will be tax-free as well (as long as the owner had held the Roth for five years or more). Imagine inheriting an account that grows tax-free during your lifetime and pays you tax-free amounts on a yearly basis!
So my really smart mom put probably $4K in an IRA early. She rolled it to a Roth as soon as the rule allowed conversions. (She also contributed the max she could to her employers 503B). She kept the Roth invested and named me the beneficiary. When she passed in 2006, I CAREFULLY read the rules and found a broker that would allow me to take the RMD over my life expectancy in the IRS tables. (instead of 5 years–not everyone would). I have the benefit of a tax free nest egg and an annual gift from mom that gives me more annually than she ever contributed! I am in a higher tax bracket than she was, and I pay $0 in taxes on that RMD. Her actions remind me constantly to learn and read and understand the rules.
If I contribute to Roth IRA, I lose the ability to tax loss harvest. In a taxable account I can invest in low risk tax free bonds and pay LTCG (usually at a zero rate) at MY discretion. Maybe snag a 3K ATL deduction now and then. No rules with a taxable account. I can gift/donate appreciated assets and have step up basis at death. Only a Governmental wealth tax would stop me.
My strategy is to maximize my 401k and then take selective distributions to a taxable account prior to age 70. I am going to pay tax on it either way. The QBD (if employed) adds an interesting twist since I can bring down TIRA/401k bucks to even up my taxable income. This new law makes working in retirement much more attractive.
The only advantage I see to a Roth is it is not included as income for Social Security. If I was younger maybe contributing to a Roth would make sense for its long term tax free appreciation. I do not trust the Government not to change the law over a long term period.
I think timing explains why Roth IRAs never appealed to you, and this is one of the only blogs that I read that isn’t super-positive on Roths.
You became self employed soon after the Backdoor Roth IRA (no income limit!) was made possible in 2010 [1]. It took a few years for it to become popular/the knowledge to spread, and after you have money saved in SEP IRAs from self-employment, the pro-rata conversion rule basically negates the ability to use the backdoor. [2] Finally early in your career, as you’ve mentioned, it didn’t make since since maxing the 401k was better.
Backdoor Roths have been popular for some time and are now officially IRS blessed, but I haven’t heard of a single case where someone got whacked from 2010-2017 even before the official clarification. I’ve contributed to a Roth IRA since the second year of my college and I think it’s one of the best financial decisions I made early – ability to withdraw contributions penalty-free in case of need, tax-free growth.
Now that I’m full time employed I have access to 401ks but it’s still good to have tax diversification, and tax-free growth and withdrawal is still better than taxed growth and withdrawal (fully taxable accounts) or tax-free growth but taxable withdrawals (traditional IRAs above the deductibility limit). After you max out the 401k at $19K annually, Roth IRAs really are the next best choice (“paying more taxes notwithstanding”, besides HSAs you don’t have too many other ways to stash away money tax free)
[1] https://www.forbes.com/sites/jimdahle/2018/11/16/celebrating-ten-years-with-the-backdoor-roth-ira/#41a891d5ce7e
[2] (if you have $50K in a SEP IRA and want to put in a $6K contribution to your Roth IRA via the backdoor, you’ll end up being taxed on 50K/(50K+6K) * 6K = $5,357)
An easy fix to all these mental gymnastics, crystal ball prognosticating is to just make enough money to max out 401k (hopefully your plan has after-tax and in-plan Roth conversations–gives you an extra ~10-40kish in Roth per year depending on how much your employer contributes), max out HSA, max out IRA, and have enough left over for your brokerage account. Easier said than done for some people though.
Also, would be fun to run the math on whether an after-tax investment account with the capital gains taxes and how those gains push you into a higher tax bracket and whether or not it would be close to as beneficial as paying off mortgage debt instead now.
Backdoor Roth IRA has the disadvantage of triggering a 5-year rule where you cant take out your initial contributions (and earnings) without getting the 10% early withdrawal penalty. You would have to wait 5-years to withdraw your initial contribution penalty free. But if you are not going to touch the money till later and build a large nut then no big deal.
A regular Roth IRA you are allowed to withdraw the initial contribution at any time, making that account much more flexible.
Maybe if your city and state hadn’t raped you so much in taxes; you would have been able to afford to invest for your future?
Life has been a struggle, but I feel OK supporting my city to help fund services and infrastructure for all. Just have to keep my head down and work harder and smarter. Hope you’re doing well.
Forgive me if others have already pointed this out. If you work for an employer that offers a match on your Roth 401k contributions, then your contributions will go into a Roth 401K BUT the employer’s match will automatically go into a traditional 401k. You get the advantages of both tax-deferred and taxable retirement accounts by choosing the Roth 401k.
It absolutely is true that federal tax rates are down now compared to say 10 years ago, which to this guy makes those of us buying into Roth losers and chumps.
But stop and think for just a second why taxes are down compared to 10 years ago.
Isn’t that entirely and solely due to our dysfunctional political system cutting taxes while simultaneously not cutting spending, adding to the deficit , adding to the debt?
Right now, we’re like a proverbial lobster enjoying the warm water bath some nice person dropped us in.
Unlike said lobster, we know someday, probably the day I retire in about 15 years, with my luck, the debt will no longer be ignorable and something will have to give.
Unless one actually believes deficits don’t matter, ever, no matter how large they become, one has to believe that taxes will rise by then and SS benefits will reduce in order to bring federal tax revenue and spending can come into more of a harmony.
This guy needs to understand things being the way they are now is no indication things will always be this way. Hence the wisdom of the Roth. Isn’t that always fhe financial co’s disclaimer “Past results are 100% unrelated to future results”?
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The Roth is not a OSFA solution
Probably makes no sense to anyone who hasn’t amassed sizeable retirement savings to begin with, and probably makes absolutely
no sense to anyone struggling to save anything.
But if one believes taxes will have to eventually go up, SS will be means-tested to the extent that one won’t receive expected benefits and one will have sizeable retirement assets at retirement time, Roth makes a ton of sense.
Roth conversions might make sense to some but I don’t have such large piles of cash lying around now to pay the taxes to convert. Maybe if I win the lottery I could pull it off. Obviously winning the lottery makes the Roth/conventional debate moot.
One of the benefits for society is the willingness for Roth IRA investors to pay taxes upfront. So I thank you for your contributions.
Best of luck on your path to retirement in 15 years or so.
“It’s only when I have to pay a surprise tax where the liability wasn’t properly budgeted where have a problem” This statement the above comment of “Do you know the exact tax brackets they are in now in retirement versus while working in their income is?” is exactly the issue here. There are new, hidden taxes in retirement that are hard to factor in. The worst is what Scott Burns calls the “Torpedo Tax”. The a tax that adds in your Social Security income to your regular income for tax when your regular income (e.g. pretax retirement withdrawals) is above $32,000/yr. This is not adjusted for inflation, so its impact increases over the years. You have to go through the math, but in the very worst case this causes the effective marginal rate on a dollar of regular income to be in the 40% bracket. (This happens at about $120,000/year, right now, but will climb down over time.) Then there are Medicare premiums that are increased up to 4x of the “normal” premium, based once again on “regular income” (e.g. pretax retirement account withdrawals). I believe all this complexity is an intentional obfuscation so you don’t make the best overall lifetime tax decisions. It’s up to you to plan, plan, plan.
I do know a few retirees who are in a higher tax bracket now than in much of their working years. Not because their income is higher-it’s about the same between SS, pensions and 401k & IRA RMD’s-but because they have lost so many tax deductions they had when working. Not saving for retirement means no shelter from 401k. Paid mortgage means no more interest deduction. Grown children means no more dependent exemptions, child credit, child care credit, college expenses credit, or 529 plan deductions-significant with multiple kids. Not sure if the same is true under current tax law but I think it is an important point to consider your taxable income is made of income AND deductions so changes to both should be considered before presuming future taxable income.
Great points! Do you know the exact tax brackets they are in now in retirement versus while working in their income is? It would help to understand better with numbers.
I’m thinking the difference Cant be very much can it?
I’m not their tax accountant but will try to give some details. One was where a blue collar worker took the company’s lump sum pension as a traditional IRA during Great Recession market crash (living off spouse income until spouse retired) and account doubled in recovery. Never made much in job but doing very well now. Withdrawals plus SS are similar overall income but SS is taxable and kid & house deductions now gone so overall taxable income higher, and RMD post 70 will still trigger SS taxes mentioned below when they thought they would be under because they never made much.
Another was small business owner with large family who complains about now paying too much in taxes with no deductions to offset like he used to have. He was probably used to writing off family insurance, home office, car, phone, “workcation” travels, spending money for kids who worked in business during breaks and summers and other business deductions that go away when the business closed. Spending seems to have increased from working years to fulfill bucket list. I’d guess requiring withdrawals from well funded 401k. Former company had a generous age-based discretionary company contribution that primarily benefited owner as oldest worker.
A third was surprised to inherit an IRA from parent and complaining about RMDs from it makes her taxes too high.
A fourth took a large one-time withdrawal from 401k (only investment) a few months after retiring (I think bought a lake house) and was shocked next April that a half year salary plus those withdrawals sent him into the highest tax bracket so had to take another one-time withdrawal to pay the taxes, which made that also a higher than expected income year.
Another moved states to be near family for health reasons post retirement and is now paying state income taxes on retirement income she never paid when working.
Maybe they are all small dollars and people that age have nothing else to talk about besides their health and what’s on TV but all were very bothered by paying the “unexpected taxes” and the conversations eye opening for me as RMDs were not on my personal radar at the time. I could see a case for not maximizing pretax investments for 40 years.
I do not have a Roth, but my 22 year old granddaughter has one. I started the Roth when she was age 18. She will not truly understand the concept until later in her life. By the time young adults figure out the need, it’s too late. Compounding needs to start as early as possible. Grandparents help your grandchildren now, not in just estate planning.
I have a slightly different and pessimistic view of the Roth IRA. I was 18 and in the Army when it was introduced, and I have a firm belief that for people my age it will be bad. The Roth IRA is tax free today, and if enough people invest in them, when it comes time to withdraw the government will probably begin to tax it, though at less of a rate than a traditional 401k. Almost 50 years from the ineption of the Roth until my
first withdrawl is plenty of time for Congress to need a new revenue stream and an untaxed amount of money held by a bunch of retirees could look lucrative.
It’s a warranted pessimistic view. I think you’ll enjoy this post: Disadvantages Of A Roth IRA: Not All Is What It Seems. The government hasn’t done a good job managing the federal budget. As our population ages, there will be an steady increase in social safety net spending. Hence, good to diversify.
So don’t invest in ROTH accounts because you suspect they will be taxed on the back end in the future?
If we are going to speculate about what “might be”, then how about the government will seize all investment accounts and personally owned property? Everyone will be assigned a universal income with caps? That is no way to plan for the future.
That is bad logic. I will make decisions based on the facts and law as it stands today.
I read somewhere that out 100% of retirement accounts that only 10% are in Roth accounts. There’s just not enough money there to tax
I decided to start doing partial Roth conversions on my IRA to lower future RMDs and have my investments grow tax free. If I just took the RMDs and invested the money, I would still have to pay some tax on the capital gains. Also, assuming markets always recover, doing the conversion during a market downturn also cuts down on the taxes I have to pay now and then lets the money grow tax free when the market recovers.
Right now I have a 401K and a Traditional IRA for my retirement accounts. If/When I quit my current job, I plan to rollover my 401K to an Roth IRA.
This is an interesting post. In a much commented-on post from a few years ago you listed all the reasons why a person should NOT invest in a Roth account. That was a thought-provoking post for me that really made me reflect on my long history of making Roth contributions. While I didn’t agree with all your conclusions, I was much smarter for having read it and really examining my own motivations. So thank you for that, and this is a great follow up.
I always enjoy reading peoples personal experiences in the comments, so I though I’d share mine. I opened up my first Roth IRA in 1998, the first year they were available. It was my very first retirement contribution. I have maxed out my Roth IRA every year since then, with the exception of 2013 when my income was too high for a Roth infusion (a one-time event, income-wise). I have gone along for the ride as the contribution limit rose from a paltry $2k to the current $6k. I’ve also had the good fortune of working for a number of employers that offered a Roth 401k, which has allowed me to make substantial additional Roth investments over the years. Despite the drawbacks you previously articulated regarding Roth accounts (which are very real), I’m very glad I stuck with Roth. About 50% of my retirement holdings are now of the Roth variety. Yes, I paid a lot of income taxes over the years that I didn’t have to, but I feel the future tax savings and the flexibility a Roth provides have been worth it. I have older family members that have huge tax liabilities on their traditional accounts, and it weighs heavily on their minds at a time in life when they should be enjoying a stress-free retirement.
A few previously unmentioned advantages of a Roth that I’d like to point out:
Flexibility: Once I reach the 59.5 yrs of age I can take distributions from my traditional accounts right up to the point I would move into a higher tax bracket, then switch to taking Roth money out. Allows a person a lot more flexibility/control in keeping their taxes at a lower rate. May also provide flexibility in keeping SS taxes lower.
Effective Contribution Limit: In a very real sense, you are able to contribute more $ to a retirement account with a Roth because every dollar you put in, and all future cap gains and dividends, are tax free. Putting $6k in a traditional account is really like putting closer to $4500 when you consider future tax liabilities, not to mention gains and dividends (that’s not even counting state and local taxes). Yes I know, you could take the tax savings from traditional ira contributions and invest them elsewhere, but from a strictly “get as much $ as possible into tax advantaged vehicles” perspective, your effective max contribution limit is higher with a Roth.
As you have often state, financial decisions are really based on an individuals situation. My experience will be different than others. When I lived in high state income states like CA and OR, I decided not to contribute to a Roth 401k (though I did max my roth ira) because paying that extra 8-10% to the state made the math untenable for a roth. I’m now in a no income tax state and pumping every dollar I can into Roth IRA and 401k.
Thanks for all the great post here on FS, and keep up the great work!
We were ineligible for a number of years, but this year we only had partial income (retired), so will max out both our Roths. It’s nice to be dropping out of the max tax brackets.
For the next 5 years we’ll be in the 12% bracket and will be doing Traditional to Roth conversions within that bracket. The current structure has the RMDs killing us with Tax Bracket bumps in 12.5 years.
I will hit the incline limit this year.
But I don’t know what I need to do about it.
It’s not like I get contacted and told to “stop contributing” by anyone.
Guess I’ll keep contributing until my tax preparer says stop?
Sam you may not be able to contribute to a traditional Roth Ira but I assume you have a solo 401k plan which you have the option of doing a Roth 401k. There are no income limits on the solo Roth 401k but you can only contribute $18.500 as an employee contribution in 2018 (20-25% employer contribution must still be traditional). In the current historically low federal tax environment it makes more sense than ever before to do the Roth in addition to the other reasons such as RMDs, withdrawal flexibility starting at age 59.5 etc.
Any thoughts on Roth 401ks? Our family annual income is $400k, in high tax CA.
Highly doubt we could ever have that much income in retirement. The plan is to move to a no income tax state when we burn out.
Thanks Sam, excellent website.
Phil,
I max out my 401k and divide the contributions 50/50 between a Traditional and Roth 401k. If nothing else, it will be a hedge to whatever happens with future tax rates and diversify retirement income. We have a similar household income in the state of TX.