“Disadvantages Of A Roth IRA: Not All Is What It Seems” ignited a flurry of responses from people who have already been contributing to a Roth IRA. Anybody who followed my advice since the post was first published during the Obama administration has been rewarded handsomely. Income tax rates declined under the Trump administration. Let’s look at the only reasons to ever contribute a Roth IRA in this post.
With Joe Biden as President, at the margin, investors should be more wary because there’s a likelihood that taxes will go up again. Taxes must be raised to pay for all the stimulus being spent to combat the virus. Further, Biden has said he will raise taxes on households making more than $400,000.
Hard To Trust The Government
One of the main things people have learned is that the government manipulates individuals into forking over more money than they otherwise should due to gross mismanagement of their own budget.
Massive deficit due to record stimulus spending during a coronavirus pandemic? Let’s announce this huge “benefit” to allow people to convert their pre-tax retirement funds into a Roth IRA! We’ll raise the specter of higher tax rates to get more people to bite.
It’s sometimes daunting to go against the government because they employ some of the smartest people on Earth to keep themselves in power while keeping the rest of us dependent on their largess. But I’m here to help you fight back and live a better life.
If you contribute to a Roth IRA or convert your pre-tax retirement accounts into a Roth IRA, you aren’t going to be damned to hell. You’re just not maximizing your wealth over time if you are in a federal income tax bracket higher than 24%.
For those of you who already have a Roth IRA account, what you are about to read probably makes so much sense you might feel a little bad. But don’t worry. The number one solution when you are in a hole is to stop digging and slowly climb out.
The Only Reasons To Ever Contribute To A Roth IRA
1) You’ve maxed out your 401(k) already.
If you’ve contributed $19,500 to your 401(k) for 2021, then go ahead and contribute to a Roth IRA if you are eligible for tax diversification purposes.
Contributing to a Roth IRA is more tax-efficient than simply investing in a taxable brokerage account. Roth IRA money compounds tax-free and all contributions and earnings can be withdrawn tax-free once you’ve kept your Roth IRA open for more than five years.
Related: How Much Should You Have Saved In Your 401k By Age
2) You’re in the 24% marginal income tax bracket or lower.
If you earn under $86,370 / $172,750, you are in the maximum 24% marginal federal income tax bracket I recommend for contributing to a Roth IRA. A 24% federal marginal income tax bracket is a reasonable rate to pay.
Feel free to contribute up to $6,000 to a Roth IRA now because you will be completely creamed by the IRS in the future as your income and marginal federal income tax rate increases.
The reality is, once you earn more than $140,000 per person or $208,000 per married couple, you can’t contribute to a Roth IRA anyway.
3) You’re going to make over $140,000 or your spouse is getting a big raise.
After you make over $140,000 as an individual or $208,000 as a married couple for 2021, you can’t contribute to a Roth IRA. You can contribute the max if you earn $125,000 or less as an individual or $198,000 or less as a married couple. It is still unknown how the government comes up with such arbitrary amounts, independent of location.
Don’t they know that San Francisco is much more expensive than Des Moines? Contributing to a Roth IRA is particularly useful for those who are on the hunt for sugar mammas or sugar dads. If your prey actually proposes, then contribute as much as you can during the engagement before it’s too late.
4) You think World War III is on the horizon.
If you think world leaders no longer respect the United States’ might and plan to invade, conquer, and bomb neighboring countries around the world, you should consider: 1) withdrawing all your money and keeping it under a mattress, 2) make sure your savings accounts are no larger than $250,000 for an individual or $500,000 for a married couple to comply with the FDIC guarantee amount, 3) sell equities and keep cash, 4) or contribute to a Roth IRA because the government will likely raise taxes on everyone to fund a long war.
I still think if you make under $200,000, you’re relatively safe. However, with an expense as large as World War III, the government may have no choice but to raise taxes on people paying 25% or less.
Related: How To Prepare For World War III
5) You feel tremendous guilt for not paying your fair share.
Let’s say you’re having a guilty conscience for not paying enough taxes because you either cheated on your taxes for years, run a cash only business with two sets of books, mooched off the government longer than you should have, or feel so bad taking advantage of all the loopholes, then go ahead and contribute to a Roth IRA.
I’ve spoken to a lot of the 47% who don’t pay income taxes during my time off from Corporate America, and a couple have admitted they feel bad that 100% of the tax burden is paid for by only ~53% of the people. Some of my 47% friends have side jobs that are cash only and never pay taxes.
6) You’re undisciplined and expect to have a lot of problems in your life.
You may have the best intentions of saving for your retirement, but you know that you have poor discipline when it comes to money. Perhaps your experiences as a relapsing cigarette smoker or drinking alcohol have given you doubt about never needing to raid your retirement accounts. Maybe you’ve got outstanding debts that must be paid or else goons will visit you in the parking lot and break your kneecaps. Who knows.
The “good” thing about a Roth IRA is that you can withdraw the money you put in penalty free, just not the earnings. The only times you might be able to get away with the early withdrawal penalty before 59.5 is if for college expenses, medical expenses greater than 7.5% of your adjusted gross income, or paying for a first-time home purchase (up to $10,000).
7) You have inside information knowing that Roth IRAs will get favorable treatment.
Let’s say you work in the US Treasury and overhear that the government plans to pilfer all 401(k) and traditional IRA accounts by raising taxes on withdrawal rates and extend the penalty free age of withdrawal from 59.5 to 69.5.
You’ve seen draconian measures executed with bank deposits in Greece in 2013 so you have no doubt America can do the same. You also hear that anybody who contributes to a Roth IRA will get a one-for-one dollar match and get two votes to raise taxes on others to benefit yourself. Clearly you should contribute all you can to a ROTH IRA until the government changes its mind again.
8) You live in one of the no state income tax states.
Federal income tax is one thing, state income tax is another. If you live in Texas, Washington, Florida, Alaska, Nevada, South Dakota, Wyoming, or New Hampshire, it is less of a sin to contribute to a Roth IRA because you aren’t paying any state income taxes. Everybody else should figure out a way to retire in one of the seven no income tax states and then start withdrawing pre-tax retirement funds.
Related: States With No State Tax Or Inheritance Tax
9) Someone is paying you to promote a Roth IRA.
Money makes people do anything. If some organization is going to pay you to promote the Roth IRA then I guess you’re better off than others who don’t have the same money making opportunities. If you can earn more promoting the Roth IRA than what you can earn from the returns of your Roth IRA, then you would be a fool to ignore all the wrong reasons for contributing to a Roth IRA in order to pad your bank account.
Be especially aware of financial advisors or CFPs who aggressively push the Roth IRA without providing other benefits besides tax free growth and gains. Make sure pitchmen practice what they preach.
10) You are an income tweener.
If your income is between the deductible IRA max ($66,000 income limit to contribute the max) and Roth IRA max ($140,000 income limit to contribute the max) and you can afford it, making a Roth contribution could make sense.
For those over the Roth income max, you can do a “backdoor” Roth contribution – by making a non-deductible contribution to a traditional IRA and then converting it to a Roth.
11) You’ve got a working child.
If you’ve got a child who is working for someone else or for your business, then you might as well contribute to a custodial Roth IRA. The child will pay no taxes up to the standard deduction of $12,550. Further, your child will learn about the importance of saving and investing for his or her future.
There is no age limit to open up a custodial Roth IRA for you child. So long as your child is earning income doing work, he or she is eligible.
Contributing To A Roth IRA Isn’t The Worst Thing In The World
Mathematically speaking, the most taxes you will pay on a $6,000 contribution is roughly $1,440 (24% tax bracket). You can’t contribute to a Roth IRA once you’re in the 32% federal income tax bracket due to the $140,000 individual income limit threshold for 2021.
It is really unlikely that you will earn more in retirement than while you were working. Interest rates have plummeted, which means it requires a lot more capital to produce the same risk-adjusted income. Therefore, we should all lower our safe withdrawal rate in retirement to be more aligned with the times.
You will unlikely earn enough in retirement to pay higher than a 24% marginal federal income tax bracket. This would require an individual to make over $165,000 a year or a married couple over $330,000 a year in retirement to pay the 32% marginal federal income tax rate.
However, to generate $165,000 / $330,000 a year in income from your retirement portfolio would necessitate having a $4,125,000 – $8,250,000 generating 4%. But since interest rates have come down, you would need perhaps double the amount.
Yes, I do believe many personal finance readers will become multi-millionaires in retirement. But most Americans will not. The retirement numbers don’t lie.
If the choice is between not saving anything at all and saving in a Roth IRA, then definitely save in a Roth IRA even if you haven’t funded your 401(k). But the best sequence is to max out your 401(k) and traditional IRA first before paying more taxes up front.
Diversify Your Retirement Sourcs
In 2021+, I have come around to contributing to a Roth IRA because I’m now a father of two kids. So much of one’s perspective changes after becoming a parent.
When I reflect back upon my time working minimum wage jobs as a teenager and then working jobs in college and a year after college, I regret not contributing to a Roth IRA. If I did contribute a Roth IRA back then, I would have over $100,000 in a Roth IRA account today.
I plan to put my kids to work at some point, pay them the Roth IRA contribution limit, teach them about online entrepreneurship, and also teach them about the importance of saving and investing for the future. Being able to pay 0% tax to contribute to a Roth IRA and then withdraw the money tax-free in the future is a no-brainer.
Joe Biden and Kamala Harris are likely going to raise taxes for higher income earners and keep taxes the same for the rest. Pay attention to tax laws and tax rates going forward.
Recommendation To Build Wealth
Analyze your investments for excessive fees. Whether you have a Roth IRA or a traditional IRA, I would sign up for Personal Capital to run your retirement funds through their Investment Checkup tool for free. You’ll get a snapshot of how much in portfolio fees you’re paying a year and how you can optimize your portfolio based on your risk tolerance. I found out I was paying $1,700 a year in fees I had no idea I was paying!
Definitely also run your numbers through their newly launched Retirement Planning Calculator. They use real data that you’ve linked to produce as realistic a future financial scenario as possible to see how you’re doing. You can adjust the various expense and income variables to see the different results. Check out a sample output below and see if you can get to excellent shape as well!
There is no better free online tool that has helped me stay on top of my finances more than Personal Capital. It’s important to aggregate all your accounts to get an entire overview of your net worth to make proper changes. It only takes a minute to sign up.
Partial Roth conversions from a traditional IRA are an alternative to using the 72t SEPP to turn tax deferred income into nontaxable income without paying any taxes or an early withdrawl penalty. The way I like to use my early retirement is to be a mega tax optimizer as opposed to a mega wealth generator. The goal of my working career was to store as much income as possible in tax deferred accounts, and the goal in retirement is to get all that money out without paying any federal or state taxes. I moved about $440K last year from tax deferred to available or spendable categories last year, paying $0 Fed and $0 California tax, and I am happy as a clam with that!
I’m very familiar with Roth conversion ladders and all kinds of tax optimization tricks such as those GCC shares. But can you share more info on how on earth you moved $400k of tax-deferred pretax over in a year without paying tax? I can’t think of any way that could be done that wouldn’t also have cost you a lot of money in other ways.
I was referring to my focus on mega tax optimization with that figure. About $370K of that was a capital gain on a primary residence I held for six years. The other $70K came from multiple tricks due to married filing jointly status, but heck, avoiding the Federal component of taxation is simple for under $70K just from the long term capital gains or qualified dividends exclusions! The state portion is actually easy to hide anyway in California since the tax structure is *so* progressive compared to other states.
Quick follow up on my comment about my focus on tax optimization over wealth generation.
First, you can generate as much wealth as you want in tax deferred accounts, especially with Solo 401(k) that let’s you choose *any* investment vehicle. So wealth generation is always doable and important, but not my focus.
Second, at some point I realized that someone making $47K retired could live *exactly* the same lifestyle (if not better) as the majority of people who make $100K working. Since I am content with a $120K lifestyle with no need to “live large” I decided to focus more on maximizing every dollar I made vs making as much wealth as possible.
That, in a nutshell, is why I am a FIRE guy that focuses on optimizing taxes instead of generating wealth.
Besides, generating wealth requires a lot more effort than optimizing taxes. :-)
My company offers a mega-backdoor roth (in-plan after tax 401k conversions to a roth 401k) which lets me put away the IRS maximum of $56k. I see no reason not to do this because my earnings will grow tax free, I’m already maxing out my pre-tax 401k, and I can use the roth 401k as an emergency fund (well, my contributions). I see no reason not to do this, even though I would like to start using the 30k or so I’m putting into my roth 401k into a house eventually.
I understand your points in this system, but don’t believe they account for all situations. You make some statements that I am sure are true for many, if not most, of your readers. However, by the shear fact that I am a reader, they’re not true for all. I am an expat reader. You probably have more readers than me in my situation. Thus, I have to disagree that these are not the only reasons to ever contribute to a Roth IRA.
In your post:
1. “You’ve maxed out your 401(k) already.”
As an American citizen who lives and works abroad, I don’t have a 401(k). You could argue it is maxed out because the amount I can contribute is zero, but, really, I haven’t contributed anything to it either.
2. “You’re in the 24% marginal income tax bracket or lower.” And “You’re just not maximizing your wealth over time if you are in a federal income tax bracket higher than 24%.”
I am currently in the 22% bracket, but have not been far away from the 24% bracket the past couple of years. Even if I enter the 24% bracket, I think it is still to my benefit to enter the Roth IRA as an expat American in Germany. Right now, I can take a tax credit on my German income taxes, and then put the money into a Roth IRA. I get no deduction benefit from putting it into a Traditional IRA.
If and when I make enough in dividends, capital gains, and other distributions from my investments, I can just exclude all of my German earned income and contribute to the Roth as if I only had 6k in US income.
Correct me if I am wrong, but being an expat almost guarantees a Roth IRA is a better choice than a traditional IRA. The only situation I could see that being otherwise is if you can still exclude your foreign income under the foreign earned income exclusion while earning enough dividends, capital gains, and other investment distributions to be under the US income max for the traditional IRA deduction while being able to really take advantage of the tax deduction.
3. “You live in one of the no state income tax states.”
I’m guessing that you meant with this section: “you don’t have to pay state income taxes.” I do not live in one of the states with no income taxes, but I also don’t live in any state. Years ago, I formally renounced my residency in that state and have that state’s confirmation. I no longer pay state taxes, only federal taxes. And there are ways to reduce federal income tax liability substantially, if not completely. For those interested, I wrote about two of the primary ways to do so: the foreign earned income exclusion (expostriate.com/foreign-earned-income-exclusion/) and foreign tax credit ( expostriate.com/foreign-tax-credit/).
We won’t be converting tIRA to Roth IRA…our income is low and will be so in retirement, so any taxes on tIRA withdrawals will be low.
OTOH all our kids are going into the military after college, so they will be putting their retirement savings into the Roth TSP since their tax brackets will be low at first (plus they get generous non-taxed “allowances”) but they’ll be in much higher tax brackets later in their careers.
It wouldn’t matter if they are going to be in higher tax brackets. what matter is in their retirement income tax ratio. SO it would be better for them to use traditional..
Here’s another reason for people to invest in the Roth: After 35+ years spouse and I have saved in the tax deferred 401ks and as a result, wee have over $2.5 million in the tax deferred accounts. Now… we recently read the writing on the walls… Unless we do some major converting in retirement, Uncle Sam is gonna take an enormous chunk of our tax deferred savings when RMDs kick in at age 72. So, we wised up and changed our paychecks to 100% Roth 401ks until we retire. We are definitely going to have to create a drawdown strategy or Roth conversion strategy between our retirement at age 61 and RMDs at 72. So there, you have it! Another great reason for investing in the Roth!
Originally I was like you and I worried about RMD’s. However, a while ago I decided to create a spreadsheet to see what my RMD’s would look like if invested in my 401k and had a $2.5 million balance when I turned 70.5. The spreadsheet was created before the RMD was raised to 72, but it still gives you a general idea.
Here’s my sheet:
https://docs.google.com/spreadsheets/d/1szCTL1f18r-R7Mfo_fJAt9qEW_S0Xnt_cuO06aB58ao/edit?usp=sharing
Historically, the average rate of return on investments while in retirement is about 5% since the investments are mostly moved into safer vehicles while in retirement which means lower rates of returns but more stable returns. Also, historically, since the early 1920’s, inflation has averaged 2.9% per year.
As you can see in the spreadsheet, I ran out the numbers year by year showing what my RMD would look like each year.
To the right you’ll see what my taxes will look like the first year in RMD’s and also what my highest RMD tax would look like.
My max RMD occurs when I turn 84 years old in which I’d be required to take out $108,596. Using a gross of 108,596 you can see that my effective tax rate would be 16.09% after my standard deduction and my AGI is funneled through the different tax brackets.
I’m not sure what marginal tax bracket you’re in right now, but I’m in the 24% marginal tax bracket right now. Meaning any money I invest in a ROTH is going to be taxed at 24%. Ouch!
However, as you can see from my spreadsheet, if I invested in a 401k instead and had a $2.5 million balance when RMD’s start, my first year of taxes would be 14.66% and my highest RMD year would be 16.09% in taxes.
I’d much rather pay taxes later at a lower rate even when forced to take RMD’s on my traditional 401k vs paying ROTH taxes now. For me the taxes would be about 50% more, 24% for a ROTH now vs 16% later on for a traditional 401k with RDM’s.
Hope that helps people understand RMD’s a little better.
Josh,
Great spreadsheet. However, at the beginning of RMD, you’re paying a 14.66% effective rate on $79k after your standard deduction.
With a ROTH you are paying 24% (your marginal rate) only on your $6000 contribution which is $1440. In 40 working years you’ve paid ~$57,600 in taxes. Have you done the spreadsheet of the max allowed ROTH and how much total taxes are paid when you reach age 70.5 (or 72)?
With a ROTH, you pay no taxes on earnings and compounding. I’m thinking it’s great when you’re young and at some age it transitions to where it’s no longer profitable to pay the taxes up front, unless you are planning to let someone inherit it.
Hi Jim,
I understand what you’re saying and I’ve had a lot of talks with people relating to that as well.
You’re thinking of taxes now vs later in absolute dollar amounts. In that way you are correct.
With that said however, the way you should be thinking about taxes is what percentage of my income am I paying in taxes. Yes, you’ll pay more dollars quantitatively in retirement in taxes on a 401k, however your nest egg is also a lot larger with a 401k in retirement and your taxes are a smaller percentage of your retirement income later in retirement than they are now with a ROTH.
If you want a more complete concrete example, I created this a while back comparing the Roth to a Traditional 401k.
https://docs.google.com/spreadsheets/d/1IBt7ro1z97OnBRyP7PZgkZ3CevpSHKFEaOPeHRcQol4/edit#gid=0
You’ll notice, that yes, you’ll pay more taxes (in raw dollars) on a 401k in retirement, however, again, your 401k nest egg is a lot larger than the ROTH and you need to look at what percentage of your income you’re paying in taxes and what your net income is in retirement after all the taxes are paid. That’s what matters to me. The bottom line is which investment gives me the highest take home pay in retirement after all the taxes are paid. I personally don’t care if I pay more in taxes (raw dollars) later in a 401k if my net take home after those taxes are paid is greater than what I would have had if I invested with a ROTH.
The example linked shows the full circle picture of the retirement vehicles as it pertains to our actual tax code. And more importantly, it shows who actually has more money to live on per year after all the taxes have been paid. In this case, Sam (401k) has more money to live on each year than Dave (ROTH).
Hope that helps!
For giggles, I just updated/created a new spreadsheet for the 2020 tax brackets and standard deductions. See below:
https://docs.google.com/spreadsheets/d/1EZ4ig90jgVgAnPKzBxbM1uPSO8mu5dWiHbXkV0cUicU/edit?usp=sharing
As the original one indicated, Sam and Dave are both saving 15% of their income for retirement. The first tab shows this comparison.
However, I expanded on this. Why?
Because Sam and Dave are not like most Americans.
The average American is only saving 6.9% of their income for retirement. The second tab shows what Sam and Dave’s situation would look like if they are an average Americans saving 6.9% for retirement.
I also went the other extreme, what if Sam and Dave were absolute rock stars and wanted to max out their 2020 contribution at $19,500. The third tab shows this comparison. As an fyi though, only 13% of Americans maxed out their 401k’s in 2017 (I can’t find 2018/2019 data).
In the end, all three tabs show the same thing. The 401k is more advantageous than the Roth and Sam has more money to live on per year than Dave does after all the taxes are paid.
Other things to think about, these scenarios show Sam and Dave contributing for 40 years. Which the typical American also isn’t doing. I could easily create a spreadsheet where they’re only investing for 30 years instead. But the same thing would happen: A shorter period of time investing means a lower retirement balance, which means less money taken out every year in retirement which means an even lower effective tax rate on their 401k withdraw in retirement. So even when time is taken into consideration, the 401k comes out on top.
Hi Josh,
Thanks for the second and third spreadsheets!
It’s a win-win for the individual and Uncle Sam.
Amazing that in 40 working years Dave would pay just $105,600 in Federal income tax whereas in 25 retirement years Sam would pay over $340,200… yet Sam will have higher income throughout retirement.
It’s a bit of a shame that the stretch IRA was removed as part of inherited IRAs. I was relieved to learn that the QCD age stayed at 70-1/2 and was not increased to 72 like the RMD age. I turned 70-1/2 this year.
Thanks for the spreadsheet but what happens when the government raises tax rates in the future. I’m currently in the 24% tax bracket and will also have SS and a federal annuity in retirement. Both will be taxed. Shouldn’t I have a Roth to off set all the taxable income I will have in retirement? I’m still 20 years away from retirement.
I’m confused by your position, can you help me better understand?
If you contribute $5,000 to a Roth, you’ve already paid taxes on that money. It grows tax free, and you get to spend it in your golden years. The only alternate option would be to invest that same money elsewhere (I max out my 401k), and pay capital gains on the earnings.
Am I misunderstanding something?
Yes because you’re paying taxes on a ROTH investment at your Marginal tax rate, which is your highest tax bracket. If you invest in a regular 401k, the withdraws are treated as normal income so you get to take a standard deduction and then the money is taxed in tiers. This is considered your effective tax rate. Your effective tax rate is always lower than your marginal tax rate. If you don’t believe me look at your tax summary for the past year.
For example, My marginal tax rate last year was 24%, however my effective tax rate was 12%.
Every dollar I put into a ROTH would be taxed at 24%. Ouch!
I agree with the author 100%. The vast majority of the people reading this will retire on less income per year in retirement than they had while they were working. In fact, most financial advisors suggest 80% income replacement is a good goal to strive for. And in that case the regular 401k is definitely better. If you’re one of the unicorns that can retire on significantly more money in retirement than they had while working, then it would be beneficial to diversify.
The sad reality is that the vast majority of the public won’t even hit 80% income replacement and their retirement fund is severely underfunded. So why would you want to pay high taxes right now on a ROTH when you can pay lower taxes later on a regular 401k? That doesn’t make sense.
I think it depends on where you are at in your career. It is true that most people will retire in less money than they make at the end of their career, but most people will retire making far more than they did at the beginning of their career.
So early in your career it probably makes sense to co tribute to a Roth and then transition more and more of the contributions into a traditional as your income increases.
I also suspect tax rates in general will go up, so having some money in a Roth to mitigate tax risk is nice, but I know that’s speculative.
Another point is that if you contribute $10k to a traditional and $10k to a Roth the Roth will win 100% of the time because the withdrawals are tax free. The only way the traditional can compete is if you also invest the tax savings. So for example you contribute $12k to your traditional instead of $10k to your Roth, because Both reduce your take home pay by the same amount.
Max,
Of course if you invest $10k into a Roth and $10k into a 410k the Roth will win, everyone knows that because you’re investing MORE money in the ROTH that way. That’s a no brainer. That’s also not an apples to apples comparison because your take home pay right now suffers because you’re paying the taxes on your $10k ROTH investment from your take home pay.
How is that a fair comparison of which one is better?
If you want a true apples to apples comparison, you need to take your Roth investment of $10k, pay the taxes on it and then invest the remaining amount. If you’re in the 24% tax bracket that means that you’re investing $7600 into your Roth and paying $2400 in taxes or you’re putting $10k into your traditional 401k. That is the only way to get a true apples to apples comparison because your take home pay stays the exact same right now. If your take home pay is the same now, then you can compare which is better in the future.
There are a lot of people claiming the ROTH is better, but I have yet to see anyone run an apples to apples comparison with actual Math calculations comparing them using real income and realistic inflation and rates of return.
I have, I have tons of spreadsheets just like the Samurai does which proves the traditional 401k is better for most people. If you don’t believe me, then give me your stats and I’ll run a scenario for you. I am a tax, math and excel nerd, I have run hundreds of scenarios so I know that for most people the traditional is better.
I understand equal contributions isn’t an apples to apples comparison. I only made the comment for other readers that might not be aware that you have to also invest the tax savings in order to receive the benefit of the traditional 401k.
My larger point is still valid though. I have a financial blog of my own where I run the numbers for several different scenarios. Financial samurai doesn’t let you post links in the comments but if you’re interested I can probably find a way to show you the article with the math. But if you’ve run your own spreadsheets you probably already know the big picture.
If you are looking for a specific example where the Roth makes more sense I would offer this one, which applied to me:
Young married couple has a combined household income of $100k. Both have a very reasonable expectation of making $250k combined when they retire (Government jobs with defined pay scales). The difference between their current tax rate and their anticipated future tax rates dictates that they should contribute to a Roth. However as they start to realize their raises, their current tax rate gets closer to their retirement tax rate they should transition their contributions to the traditional.
I’m interested to see what your spreadsheet would say about that scenario.
Mine show Roth as the clear winner.
I agree that for many people, especially with flat income profiles traditional is better.
The one thing that you’re not taking into consideration is inflation.
I mean if I’m making $100k right now, I’d suspect 30 years from now I’ll probably be making around $250k as well. Using some online calculators (https://www.cchwebsites.com/content/calculators/AnnualReturn.html), this works out to a 3.1% raise per year, which again, is more than the national average raise of 2.7% per year. So if you’re getting a 3.1% raise each year you’re doing better than the average person out there.
We can break this problem down two different ways: We can forecast what the tax brackets will be in the future based off inflation OR we can back track $250k to see what it would be worth today based off inflation and then compare it to our current tax brackets.
Lets take the first option: Adjust the tax brackets each year for inflation.
So if the couple makes $100k right now that puts them in the 22% tax bracket. Right now, inflation is about 2% per year and the brackets get adjusted every year based off inflation. For 2019, the 22% tax bracket maxes out at $168,400 for a couple. If we adjust this up 2% every year for inflation, in 30 years from now, the 22% tax bracket will be maxing out at $306,692. So in this case, even though the couple is making $250k/year when they retire, they’re still squarely in the 22% tax bracket.
Now lets look at it from the second point of view and adjust our $250k backwards based off inflation over 30 years.
Here is an online calculator to figure out present value based off a future value and inflation. If we enter $250k as our future value, 2% as inflation, and 30 years as the length, we can see that $250k 30 years from now would be worth about $138k right now. As we saw above, the 22% tax bracket for 2019 tops out at $168,400. So at $138k, we’re still squarely in the 22% tax bracket.
https://financialmentor.com/calculator/present-value-calculator
Technically, there’s also a third way to do it….
As I’ve posted above, the math formula is (1 + ror ) / (1 + inflation) – 1. This gives you what the inflation adjusted raise would be. From above, if you start at $100k and end at $250k 30 years from now that’s about a 3.1% raise per year, which again, is above the national average of 2.7%. But anyway, plugging the numbers into the formula, we see that (1 + 3.1% raise) / (1 + 2% inflation) – 1 = 1.078%. So the couple you mentioned is basically getting an inflation adjusted raise of 1.078% per year. $100k * 1.078% per year for 30 years gives the couple an inflation adjusted income of about $138k/year 30 years from now, which is basically what we found in option 2 above. It’s good to see that we did the math two different ways and the math came out the same!
No matter which calculation option you choose (1, 2, or 3), the couple still ends up squarely in the 22% tax bracket making $250k 30 years from now. Given your scenario, this couple never leave the 22% tax bracket.
My example is one of a starting teacher salary and a GS-11 government employee. Expectations of promotions to GS-15 and maxed out MS degree teacher salary put their combined pay scales at $100k in the early years and $250k in the late years BEFORE cost of living adjustments. If you’d like to project the COLA adjustments into the future and take a guess at how tax rates will move you are welcome to do so. However, I think it is just as useful to assume that inflation adjusted tax rates will be roughly the same then as they are now and apply the current tax rate for the $250k household income to the decision. Essentially doing all of the math in today’s dollars. If COLA’s do not keep pace with inflation, or if tax codes don’t then you are correct the math will change. But I think that it’s fair to say that the situation described above will result in a much higher marginal tax rate in retirement than at the beginning of employment, so I stand by the analysis.
Also, the 2.5x multiplier is in line with typical progression of incomes according to various data sources on income quintiles by age. (Not linking because again I don’t think it is allowed). So not only do I think that the Roth is the best option for that couple early in their career, I also think that there are more people in that boat than you might expect. It’s probably not the norm, but it’s probably not uncommon.
Here is my situation that I think proves the benefit of a Roth IRA. I make too much to make a deductible contribution to a traditional IRA. Therefore, I make a non-deductible trad contribution and then a conversion to a Roth. I make marginal tax rates on this contribution regardless if it is into the trad or Roth. If I were to leave it in the traditional then I would owe taxes in withdrawal AND have an RMD, right? I’d be taxes twice.
Am I right in this thinking?
Scott
After $6 trillion in new spending to combat Corona Virus I like my odds that my Roth will payoff in the long-run…
I have done a lot of math on the Roth vs 401k vs brokerage analysis and I don’t view Roth’s nearly as unfavorably as the author seems to. Generally speaking, I would say that most early career people make much less than they will make when they are in their prime earning years when they retire and therefore a lot of people are in much lower tax brackets than they will be in retirement. It therefore makes a lot of sense for those people to contribute to a Roth. I agree that as your income gets close to your expected retirement income it starts to make sense to transition to traditional, but this could take 10-20 years. I also like that it takes income tax risk off the table, so if the total return from a traditional and a roth are close, I would argue the roth is better because you are immune from income tax increases. I also believe that with the social security/medicare/medicaid insolvency and coronoavirus responses all likely to require additional tax dollars it is fair to assume that someone’s taxes are going up, although I admittedly don’t know whose, or when.
Max, make sure you are taking inflation into consideration. You may start out making $50k/year and then 20 years later you’re at $100k/year. That sounds awesome because you’re making twice as much money as you did when you started. However even at a modest 2% inflation like we have now, that $100k would only be worth $67k in present terms money, so really in 20 years you went from $50k to $67k. That’s a 1.5% increase per year after inflation (3.5% a year with inflation). FYI, the average pay increase last year was 2.7%, so at 3.5% you’re considered better than average for wage increases but your income really isn’t exponentially growing.
I do agree a ROTH is good if you expect exponential income growth,for instance going from $50k to $100k in 2 years, but if you’re an average person getting a 2.7% raise each year, the Roth doesn’t make much sense.
But for what it’s worth, the one area I 100% suggest a Roth for is if you make under the standard deduction every year. For a single person that would be $12k. So if you make under $12k, I 100% say invest in a ROTH since you will pay $0 in taxes on that investment right now.
I don’t know that the pace of growth or inflation matters nearly as much as how much you make. For one, tax brackets aren’t inflation adjusted, so whether my wages are keeping pace with inflation or outpacing it my tax rate is still going up. Also even if the growth is slow it just means that you would transition your money from one to the other more slowly it would change which vehicle you choose.
The rate of inflation most definitely is important. If not, then please show me where I can find fuel for $0.25/gallon? How about a brand new house for $30k? Recent inflation has been around 2%. However historically, inflation has averaged closer to 3% since the 1920’s. Inflation most definitely matters!
Secondly, I have no idea where you’re getting your information from, because yes, the tax brackets are most definitely adjusted every year for inflation. Just look at the bracket maxes for the past two years. The max 24% rate topped out at $82,501 in 2018 and it maxed out at $84,201 in 2019. Which, btw, is basically a 2% inflation rate like I said before. If you got a 2% raise last year and inflation was also 2% last year, you effectively didn’t get a raise as your buying power stayed the exact same. And since the tax brackets got adjusted up 2% last year, that means you’re not jumping any tax brackets either.
For giggles, since we’ve already established that the tax brackets are adjusted each year for inflation and that in 2019, the 24% tax bracket maxed out at $84,201, if that max is adjusted every year by 2% inflation, then in 20 years from now the 24% tax bracket will max out at $125,571. So making $84k now would be equivalent, tax wise and buying power wise, to making $125k in 20 years. Your wages went up 50% over that 20 year period ($41k), but your real buying power hasn’t done anything! And tax-wise, you’re still at the top of the 24% tax bracket, you haven’t moved anywhere even though you’re making 50% more than you did 20 years ago!
There’s a math formula to figure out what the true raise would be after accounting for inflation:
(1 + pay raise rate) / (1 + inflation rate) – 1.
So if inflation last year was 2% and the average raise last year was 2.7%, then your actual raise after inflation would look like this:
(1 + 2.7%) / (1 + 2%) – 1 = 0.69%.
So even though the average raise was 2.7% last year, the inflation adjusted raise was only 0.69%. If you made $50k last year and got a 2.7% raise, your real raise after inflation is considered would only be $345 ($50k * 0.69%). You’re not exactly exponentially jumping tax brackets when your real raise only went up $345 last year after inflation was taken into consideration.
Lets drag this out further, if you made $50k/year and you got 2.7% raise every year and inflation was 2% every year, your $50k income in 40 years would be $65,887 after being adjusted for inflation. So even though you’re getting 2.7% raises every year, you never left the 22% tax bracket after 40 years of working. If you make $100k/year you’d currently be in the 24% tax bracket. Using the same 2.7% raises and 2% inflation, in 40 years your inflation adjusted income would be $132k. You’re still in the 24% tax bracket! Again, you didn’t move anywhere!
As I said above, inflation most definitely makes a very real difference and if you’re not accounting for it in your calculations then it’s going to bite you!
Lastly, the formula above is good for calculating rates of returns for investments as well. If you get a 10% rate of return on your investments and inflation is 2%, your real rate of return is (1+10%) / (1 + 2%) -1 = 7.8% after inflation is taken into consideration.
I like what you said about using a Roth IRA if you make less than $84,200 a year. My sister has been telling me about how she wants to make sure that she’s preparing properly for retirement. I’ll share this information with her so that she can look into her options for using a Roth IRA.
What is your opinion on gifting to a ROTH IRA for another person under the assumption they would not have contributed to an IRA otherwise?
In general, contribute to a Roth if you are currently in a lower or the same tax bracket now than what you anticipate in retirement. If using it as a legacy play for your kids, you are then comparing your current tax bracket to you kid’s anticipated bracket when you and your spouse die. If the stretch IRA is shortened for non-spouses such as your kids, having to empty a large regular IRA can increase their taxes tremendously. One more reason to use a Roth is that you can in a sense shelter more of your money. Most illustrations show contributing $6000 to a traditional vs $4500 to a Roth because of the 25% tax bracket. But you can put $6000 in it. The more you can shelter from taxes forever, the better, as long as your retirement tax bracket is the same or more.
The reason people compare $4500 in a Roth to $6000 in a Traditional is because that is a true apples to apples comparison. Meaning your take home pay right now stays the exact same.
If you try comparing putting $6000 into a Roth and $6000 into a 401k, of course the Roth would win because you’re putting in way more money! That’s because you’re paying your taxes on your Roth contribution from your take home pay and not taking it out of the investment. Meaning you’re take home pay right now is not the same between the two investments. That is not an apples to apples comparison.
If you want a true apples to apples comparison, you need to take the taxes out of the investment right now which is why they illustrate $4500 into a Roth vs $6000 into a 401k.
Also, assuming your income is steady, why would you want to pay 25% tax on your ROTH right now (marginal tax rate), when you can pay less in taxes later on? Your 401k withdraws are taxed as normal income meaning you get to take a standard deduction, and then the remaining AGI goes through the various tax tiers to come up with an effective tax rate. Think about this way, because of the standard deduction, if you’re single, the first $12,000 of your 401k withdraw is 100% tax free! You’re effective tax rate is ALWAYS lower than your marginal tax rate. ALWAYS!
Maybe this was mentioned already, but it appears that you are comparing Roth Contributions to deductible Traditional IRA contributions. In many cases the T.IRA is better, but in many cases income is too high to take the deduction. Then the backdoor Roth is a great choice, as opposed to saving to a taxable account with cap gains on the growth. Gift to your kids who work so they can contribute to Roth accounts – the taxes saved really adds up when you start early.
Also, finessed Roth Conversions can save a ton in future taxes when there’s a significant dip in your marginal tax rate (sabbatical year, large loss, after retirement but before social security and RMDs, etc.). For HNW, the savings can easily be over a million.
I am not paid to promote Roth accounts, but I do see that the vast majority of people who could benefit significantly from Roth IRAs (which is a higher number than you would think) are not taking advantage of them.
11) You’re a US citizen living and earning entirely outside the US.
My understanding is that if you earn within the brackets, this is pretty much the only tax sheltered US vehicle open to you… and you have to elect to take the Foreign Tax Credit (form 1116) instead of the Exclusion (2555). No?
Unless I missed it, you left off one very good reason to contribute to a Roth:
it is more favorable to inherit a Roth than to inherit a Traditional IRA, and I expect to leave much of it to my nephew after I’m gone. Under current stretch rules, he’d be able to get a nice chunk of change tax free stretched out over perhaps the final 40 years of his life.
Hmmm, could you elaborate more on this? Could be a good point!
There’s also a debate on how much one should give. Check out: Three Things I Learned From My Estate Planning Lawyer Everyone Must Do
Mike, he would also get a nice chunk of change from a Traditional IRA stretched over 40 years except that he would owe taxes on each distribution. In the beginning, distributions would be quite small if he’s young.
OTOH if he doesn’t read Financial Samurai, he just might treat himself to a Ferrari!
My husbands in the service E-6 10 year pay. I don’t work and we have 2 kids. I find contributing to the traditional TSP to be our best option. It allows us to benefit from the Earned Income Tax credit which is huge! Not only do we benefit from the EITC but also it allows us to take a larger Retirement savers credit. Tax planning is key here! If you can shelter 8k a year in a traditional TSP/401k and get back 3-4k because of it in your income return do it! We saved in the roth for years until I started tax planning.
I am 29 but have only ever had a Roth IRA since I started contributing – about $9,000.
I have access to a 401k at work, which I am using and maxing out my employer matching.
I feel a traditional IRA is smarter at my age due to the greater amount of money one can contribute (being pre-tax money) versus a Roth’s taxed money. It can compound quicker than taxed contributions.
Is it smart to convert my Roth to a Traditional IRA, if that’s even possible?
Or should I keep the Roth and contribute to a new Traditional IRA?
At least until we begin WWIII…
Sam,
I feel that I have a fairly good grasp on all the of concepts at work here, and I have a scenario where I would be a fool not to max out my and my spouses Roth options. Admittedly, my situation is quite unique. My wife and I will be adopting 3 children from foster care later this year. The children will qualify for an adoption subsidy from the state and are thereby considered “special needs”, which means that we can claim the full amount of the adoption credit for each child, a total credit of $41,520 even though our adoption expenses will be minimal. Our gross income is about $93,000. I believe that we will fail to use the entire credit during the current year or the 5 years of carryover. This means that for six years our tax rate will be $0. I am using all available ways to eat up this credit. I plan to sell our rental in the last year of the carry forward in order to do so without paying any capital gains taxes. I plan to sell and rebuy stock to reset our basis. I plan to fully fund our Roth IRAs to the limit. Any other options I should consider to use the credit to it’s max benefit?
I am over simplified things but calculating rough estimate taxation is always going to have some push backs. Lets say same amount of earning power contribution to both Roth and Traditional account. Since Roth IRA is limited to $5,500 annually (for the most part), Traditional contribution should be $5,500 / (1 – effective tax rate). For this calculation, lets use average growth of 6% annually for both accounts. We can calculate the ending balance after 30 years as follows: N=30 I/Y =6% PV=0. Lets also assume effective tax rate would be 20% on average.
This makes Traditional PMT equals to ($5,500 / (1-25%) or $7,333 annually and Roth PMT equals to $5,500. The ending balance for Traditional account would be $579,760 and Roth IRA would be $434,820. Since we already know Roth IRA paid $1,833 for 30 years, This means total tax paid in Roth IRA account equals $55,000. This makes Roth IRA effective tax to be $55,000 taxes paid / $434,820 ending balance = 12.65%
If the effective tax bracket is now at 20%, Roth IRA effective tax percentage drops to 9.49%
If the effective tax bracket is now at 33%, Roth IRA effective tax percentage increase to 18.69% These are the rates Traditional IRA or non company matched 401K needs to beat.
Please bear in mind, traditional account is a tax deferred account not tax free account. The cost of living may be going up, you may need gap insurance to cover expenses Medicare doesn’t provide etc. On average, you need 70% to 80% of your annual income in retirement. This means, even with the standard deductions on your distributions in traditional account, you effective tax bracket would only be slightly lower than your pre-retirement effective tax rate. Unless, of course, you are already near bottom of your marginal tax rate bracket.
Nerdwallet also conducted this type of analysis and Roth IRA wins in most scenarios. Regardless which vehicle you picked, just remember time, compound interest and low cost investment are your friend.
Alex, I agree with some of your math, and disagree with other parts. We’ll assume, as you say, $5500/year into a Roth vs $7333/year into a Traditional IRA since, as you say, you’re paying taxes at your 25% marginal tax bracket now for a ROTH.
I even agree with your math where you’re indicating in 30 years you’d have:
$579,760 in a Traditional IRA
$434,820 in a Roth
Here is where I digress from you however. Look at a real world example. You don’t ever pull out the entire Traditional IRA balance in year 1 of your retirement. Instead most financial planners suggest using the 4% rule for withdraws. Meaning you can take out 4% of the balance each year (adjusted for inflation) and in theory you should have enough money to last you about 30 years in retirement. This 4% rule is independent of if the money is in a Traditional IRA or a Roth as it’s applied evenly.
So if you take 4% out of your retirement account balances calculated above you’d be able to pull out:
$23,190/year for a Traditional IRA (Still need to pay taxes)
$17,392/year for a ROTH (Tax Free)
Now lets calculate the taxes owed on that pesky Traditional IRA. Assuming I’m a single tax filer:
Gross is $23,190
I get a standard deduction of $12,000 in 2018
So my Adjusted Gross Income (AGI) is $11,190 ($23,190 – $12,000).
Plugging $11,190 into the current 2018 tax brackets and you’d have to pay $1,152 in Federal taxes on the Traditional IRA withdraw.
$1,152 (taxes) divided by $23,190 (Gross income) means the effective tax rate for my Traditional IRA account in retirement is 4.97%
Subtract your taxes ($1,152) from your gross ($23,190) and you’d have a net of $22,037 after you pay taxes on a Traditional IRA.
So lets figure out the yearly difference between the Roth and Traditional IRA after all the taxes are paid:
$22,037 (Traditional IRA after I pay taxes) minus $17,392 (ROTH) equals $4,645.
So I’d be paying 4.97% in taxes and have an extra $4,645 to spend each year in retirement if I use a Traditional IRA instead of a ROTH. That’s almost a 27% difference!
Hands down, the Traditional IRA wins in this real life tax scenario!
The big takeaway is that your effective tax rate is always lower than your marginal tax rate which is why a Traditional IRA is better than a Roth IRA in most situations.
A few issues with your real life tax scenario. The first glaring hole is the limitations on IRAs are the same so you cant contribute $7333 to the traditional. I know Alex originally proposed this but you used it in your real life scenario. So assuming you plan to max out an IRA you would have the same balance after 30 years in either account. Yes one cost more to fund because your using after tax dollars but the does not infer you can contribute more to the other account.
Also the 4% rule is very sound but the point Alex made was you will need 70-80% of your pre-retirement income to retire. Which unless your making due with at a minimum $33,128… you will need more. Which means when your calculating your yearly income you need to include your other sources of income that don’t come from your IRA into the tax mix.
For example you might only be pulling $23,190 from the IRA, you will most likely have other income (unless you are actually living off 33K a year, but if that were the case you wouldn’t be paying into a ROTH at 20% anyways). In this case you dont simply plug 23K into the tax bracket, instead you would see what additional taxes you would pay on the 23K when added to your other income.
When you take into consideration that at the end of 30 years the accounts both have the same amount of money but one is already taxed…. you will see you can save more with a ROTH. Then consider you will pay taxes on the full amount in a traditional IRA over just the contributions with the Roth. In the model above you only did a year where as the real life model would be taxed year after year for 20 to 30+ years, where as the ROTH would continue grow tax free.
Not saying ROTH is better than the Traditional in every way, but I am saying this is not a good real life scenario.
So IF you max out an IRA (using 2018 contribution limits) and can live solely off 4% of that IRA, the yearly difference is
$22,037 (Traditional IRA after I pay taxes) minus $23,190 (ROTH) equals ($1,153).
NOTE: Those are your numbers…. I didn’t check the math.
Don’t forget that social security is also taxable income during retirement. That needs to be added into the effective tax rate formula.
dunno if anyone commented on this but you also have to take out your retirement in the increments you have it stored in your retirement accounts (ie 90% 401k and 10% Roth, then that is how you are able to with draw it). You can’t maximize tax savings by taking more from one account one year and another the next account.
Alex, I agree with some of your math, and disagree with other parts. We’ll assume, as you say, $5500/year into a Roth vs $7333/year into a Traditional since, as you say, you’re paying taxes at your 25% marginal tax bracket now for a ROTH.
I even agree with your math where you’re indicating in 30 years you’d have:
$579,760 in a Traditional
$434,820 in a Roth
Here is where I digress from you however. Look at a real world example. You don’t ever pull out the entire 401k balance in year 1 of your retirement. Instead most financial planners suggest using the 4% rule for withdraws. Meaning you can take out 4% of the balance each year (adjusted for inflation) and in theory you should have enough money to last you about 30 years in retirement. This 4% rule is independent of if the money is in a 401k or a Roth as it’s applied evenly.
So if you take 4% out of your account balances calculated above you’d be able to pull out:
$23,190/year for a Traditional 401k (Still need to pay taxes)
$17,392/year for a ROTH (Tax Free)
So now lets calculate the taxes owed on that pesky Traditional 401k assuming I’m a single tax filer:
Gross is $23,190
I get a standard deduction of $12,000 in 2018
So my Adjusted Gross Income (AGI) is now at $11,190 ($23,190 – $12,000).
Plugging $11,190 into the current 2018 tax brackets and you’d have to pay $1,152 in Federal taxes on the Traditional 401k withdraw.
$1,152 (taxes) divided by $23,190 (Gross income) means the effective tax rate for my Traditional 401k account in retirement is 4.97%
Subtract your taxes ($1,152) from your gross ($23,190) and you’d have a net of $22,037 after you pay taxes.
So lets figure out the yearly difference between the Roth and Traditional 401k after all the taxes are paid:
$22,037 (401k after I pay taxes) minus $17,392 (ROTH) equals $4,645.
So I’d be paying 4.97% in taxes and have an extra $4,645 to spend each year in retirement if I use a Traditional 401k instead of a ROTH. That’s almost a 27% difference!
Hands down, the 401k wins in this real life tax scenario!
The big takeaway is that your effective tax rate is always lower than your marginal tax rate!
I retired in 2008. Recently, I have been contributing $6,500 yearly from my bank Savings account to a Roth IRA for the past 4 years ($26,000 total) and has grown to approx. $34,000.
Recently, someone informed me that I cannot contribute to a Roth IRA since I am no longer working.
Also in 2008, 1) some of my retirement money approx’ly $40K was converted to IRA with a stockbroker and is currently about $50K.2) I have 403b invested approx. 85% in domestic stocks and 15% in international stocks for several years, which gaine approx. 16+% until Feb. 2018. Early in February, I converted my 403b to 60% bond, 35% domestic and 5% int’l stocks. I plan to hold it until early next year.
I would appreciate very much if anyone could give advice re 1) As a retiree, can I contribute to a Roth IRA (yearly $6,500) using my bank Savings Account? If not, what to do? 2) Should I convert my $50K w/ stockbroker from IRA to Roth IRA? and 3) Did I make the right decision to convert my 403b to 60% bond, 35% dom. 5% intl. stocks?
Thanks advance for any advice.
i am in similar situation and wondering who was the “expert” (or IRS instruction) that said you cannot contribute to a Roth IRA if you are no longer working?
Google “irs ira”. You will find the IRS definition of “Compensation for Purposes of an IRA”.
I forget where it’s specified, but I know that you cannot contribute more to a Roth IRA (or traditional IRA) than your earnings for that year; thus, it’s necessary to still be working. With the Roth IRA, there is no age limit on contributions, so it’s just the earnings requirement that would prevent people.
I max out my Roth IRA at the beginning of the year as a birthday present to myself. As a single person I do wish they would at least double the amount you can contribute annually. For me I see the most important benefit of a Roth IRA is having the ability to control the money during retirement – meaning there are no required minimum distributions so you can allow the money to continue compounding.
I am a single working mom making $72k annually. I have a dependent daughter and file as the head of the household. Which IRA would be a good option for me?
The question of Roth versus traditional really comes down to whether you believe you will invest wisely, and what tax bracket you will be in when you retire. If you don’t invest wisely, are looking at a meager return on investment and you expect you will be in a low paying job most of your life then yes the traditional IRA is for you. If you invest wisely, pay attention to the stock market, and expect to be reasonably successful in life, then the Roth is for you. Consider this, if somehow you hit it big with a stock or two, double your investments, do you want it tax free when you retire or get whacked on the taxes? It’s a no-brainer for most people…..Roth!
I 100% disagree with your analogy! She’s not taking her whole 401k out in one lump sum in retirement! She’s taking it out slowly over the course of her retirement. The overwhelming majority of people will retire on an annual amount at or less than their last year of work. For arguments sake, lets say she’s making $75 (adjusted for inflation) when she retires. If she contributes right now, every dollar she invests in a ROTH will be federally taxed at her marginal tax rate which is 22%. However later in retirement when she takes out $75k/year from her traditional 401k she’ll get to subtract off her standard deduction of $12k so her AGI is $63K. Then she’s taxed progressively on that $63k. Using the current tax brackets, her effective rate tax rate will be 13.07%. She’s saving almost 9% in federal taxes by using a traditional 401k over a ROTH. If you live in a state that taxes income, then you’d see even more savings by using the traditional 401k. I would 100% hands down rater invest in a traditional 401k and pay 13.07% in taxes when I retire versus paying 22% in taxes now.
As the author indicated. The only time it makes sense to use a ROTH is if you’re in the 10% or 12% bracket now and expect to jump to at least the 22% later on. Even once you hit the 22% marginal bracket, you’d first want to use the 401k to get your AGI down to the 12% bracket, and then after that use the ROTH for the rest. Once you’re solely in the 22% tax bracket or above, it makes no sense to use a ROTH!
Hey Financial Samurai,
Came across this article and I am having some problems digesting the tax rational for contributing to a Traditional IRA vs Roth. I did my own math and came up with the conclusion that a Roth IRA is a better vehicle than a Traditional IRA.
Scenario assuming today’s tax brackets for single filer:
*100K Pre-Retirement Income…..(932+4,294+13,488+2268 = Tax Paid of 20,982)
*100K Pre-Retirement Income with 5,500 Traditional IRA contribution is 94,500 MAGI
(932+4,294+13,488+728 = Taxes Paid 19,442)
Tax Savings of 1,540
Assuming Tax Rates Never Change
*100K Post-Retirement Income from Traditional IRA = 20,982 taxes paid = Income of 79,018
*100K Post-Retirement Income from Roth IRA = 0 taxes paid = Income of 100,000
By contributing to the Traditional IRA I save 1,540 today, but I pay 20,982 later.
By contributing to the Roth IRA it costs me 1,540, but I pay 0 later.
In this scenario, the Roth IRA is the most attractive offer. Am I missing something?
I love this site and have posted here a few times. This advice does not make sense. Any investment instrument that gives tax flexibility is worth considering. My challenge in my retirement cash flow, as for many, is a huge undesired wave of RMD from our TSP and Roll-IRAs – this produces income that, quite frankly, we do not need or want after age 70. With ROTH we can isolate income after age 70 and withdraw ROTH only when and if needed – with zero tax implications. This way we can max out our withdrawals from TSP/IRA to maximize income in the early years when we are healthy and able-bodied. Most folks with sizable retirement money (greater than $1M) will get pounded with taxes due to RMD after age 70. ROTH is also tax free inheritance to the beneficiary, so this solves the dilemma of parents desiring to leave a financial legacy to their children vs. spending down all of it on themselves. If I live to 100 and I don’t need the ROTH balances, my daughter gets all of it tax free. It is a win-win all around. The other huge benefit with any type of IRA is that you can invest with zero paperwork for taxes for gains and losses – we have made a small fortune in our Roth IRAs that are competely free of dealing with captital gains. I see zero downside to maxing out ROTH IRA if it is available to you. Lastly, any money in any IRA is not typically counted for college financial aid – it is a great way to shelter your money. My order of priority is:
1) max out TSP/401K to point of matching contributions
2) max out ROTH IRA
3) max out rest of TSP/401K
4) pay off mortgage (equity not included for college EFC)
5) pay off student loans, etc. if you have these debts.
I started the Roth as an emergency fund. I did not have the emergency fund everyone said I should have (3 months worth of expenses, 6 months, whatever) so I thought I would hedge: if there is an emergency I can withdraw the contributions, if there is no emergency then I have another retirement account. Besides, the rates I could get from a savings account were insulting. The emergency never happened (or hasn’t happened yet) and even after I reached the recommended emergency amount I kept contributing. Maybe after a while I should have switched contributions to a regular IRA but I liked the flexibility of having some money taxed and some deferred (from a 401k). My decision wasn’t the best but I feel pretty good about it, as I could have just spent the money.
Is a roth 401k or traditional 401k better for my family? My wife and I are in our late twenties, and we just received $400,000 in inheritance from a relative. On top of that, both sets of parents are extremely wealthy, and we may or may not receive additional inheritance from them down the road. We live in the mountain west (low cost of living), have two kids, and my wife stays at home. Our gross annual income is around $100,000, between my salary and our investments.
Should I max out my traditional or roth 401k at work? We’re in a very low tax bracket now and will quite likely be in a higher bracket later.
Your article assumes 1) you are not possessing of totally free and clear investment money to comfortably throw into your retirement, and are instead better served avoiding marginal income taxes now, and, 2) you have little faith in your chances of ‘beating the market’ with your investments over time.
For someone who says Financial Samurai, you should be willing to do battle!
Do battle. Use a Roth IRA to believe in your investments over time. Keep your fairly prospected gains to yourself. Don’t just throw money at the wall and hope it sticks (to your wallet).
I max out my 401k each year and I’m ineligible to contribute directly to a Roth IRA due to my income bracket – I would have to take advantage of the backdoor. It doesn’t make sense for me to ever consider a Roth IRA. At this rate I should have a 401k savings close to $3m by 60.
My fiance is in a different situation. I am trying to convince her to convert her 401k to a Roth IRA immediately and continue contributions to the Roth IRA account until marriage. I believe that the Roth IRA will give us the financial flexibility in early retirement. We will be able to access the Roth IRA after 59 and 1/2 without paying taxes, meanwhile the the 401k will continue to grow. Another option would be to draw from the 401k and Roth IRA in parallel with less taxes each year.
Overall I like the financial flexibility. I guess my question is – should my fiance switch over to the Roth IRA? We’re limited on time because our combined income will be too great to take advantage of a Roth IRA.
Currently funding our 12 and 16-year old’s Roth through income they recieve for working with us on our side hustle (sole proprietorship) ;) We write it off as a business expense (salary) and fund our kid’s Roth accounts before they actually earn any meaningful income. Decades of growth and a great head start. It’s a win-win!
We have a $20 trillion deficit right now. Social security is hemorrhaging money… when it was implemented the ratio of contributors vs. collectors was 42:1, by 2020 its projected to be 2:1, we still have 78 million baby boomers entering retirement over the next decade and the projected lifespan is continuing to go up and up. We are at a significant low point for tax rates currently, over an 80 year time line. If you believe tax rates are going to stay that way for retirement 30-40 years from now, I feel that thought would not just be optimistic, it would be naive– take advantage of the blessing that is currently among us. Personally, I believe in paying taxes 1 time, while I know where they stand, then placing them into a tax free compounding environment. All of these typical accumulation strategies only acknowledge the vehicle itself, not the erosion factors, not the risks involved with living life and not the overall impact they will have on the multiple streams of income we are working to build for retirement. Not to mention the drastic shift of tax atmosphere we walk into at that time. Compounding interest is a myth for 99% our financial world. Its really just compounding taxes for the government to sweep into their pockets at whatever tax rate they decide. Look at what the media preaches, what the government encourages us to do. If they had our true interest at heart, our world would be much much more transparent. Liquidity– Velocity of money has been and will always be the ultimate form of wealth accumulation and if you can find a tax-free compounding vehicle that will not fall onto the radar of the IRS, you will win, no matter what.
What if you are in the 15% tax bracket today? It’s doubtful that you’d be in a lower bracket in the future.
I think there is one key point missing from this article as to why someone should contribute to a Roth IRA. It’s estate planning.
We all like to think we’ll never die, but the reality is we will. What happens to our money as we enter the final stages of our lives? There are too many answers for that, but suffice to say, a Roth IRA makes the planning a lot more affordable. Why?
1. No RMD (required minimum distributions) to worry about after 70.5, meaning you get to keep the money growing even as you decline.
2. Set up your loved ones for a better life, without them footing the tax bill during their earning years.
– Imagine your the child of a parent who died and left you 1 million dollars. You’re sad that your parent passed, but now you have a tough decision to make. Lump sum of the 1 million dollars, paying taxes on that amount, OR you could have payments made to you annually based on an actuarial table for your life expectancy. Either way the taxes you pay will be added to your income and paid at the highest percentage.
If your parents had only contributed to a ROTH IRA, you’d have the same options, but without tax implications.
3. Set yourself up for a easy transition to an assisted living facility. Say you’re lucky enough to make it to age 85, and you realize that you’re having issues with the day to day. Wouldn’t it be nice to set up a trust, essentially “hiding” your money so that you can be “poorer” than you are. (My grandma just went through this with my parents as the trustees. It takes 5 years with the current laws before the government says that you are “poor.”) This would likely allow for government assistance meaning you would get to keep more of your money to pass along the ones you love.
Just keep this in mind as another benefit to a Roth… It’s not for you, it’s for those you love.
I have a question.
I am a contractor working overseas and due to the IRS deduction of the first $102800(2015) of earned income my effective tax rate is 0%. I turned 50 last month and am about to adjust my contributions to include the allowable $6000 in makeup contributions($18000+$6000=$24000).
My Employer recently added a Roth 401k option and I am wondering if I should switch into that for the duration of my contract, then rolling that into my traditional Roth IRA once my contract is over, effectively adding $70-$80k to my Roth tax free verses a traditional 401k to be taxed upon distribution.
My employer will match the first 5% for either option.
Thanks for the interesting articles, I will definitely be spending some time reading this site.
Bill
I respectfully have to disagree with the author. If you have a long term horizon, the ROTH IRA is undoubtedly superior to a traditional IRA for several reasons.
First, and this is a big one, ALL GROWTH IN YOUR ACCOUNT WILL NEVER BE SUBJECT TO INCOME TAXES. If I put $5500 in a traditional IRA, and it doubles in value, I have to pay income taxes on $11,000 when I take the money out. If I put $5500 in a ROTH IRA, I pay taxes on the $5500 on the front end (post-tax), it grows to $11,000, I pay no taxes on any of the $5500 of increased value. That is a HUGE benefit.
Second, and there are some tricky rules here, but basically, you can withdraw your principal without penalty at any time.
Third, there are no required RMDs.
All good points. See my follow up post: The Only Reasons To Ever Contribute To A Roth IRA
Hello FS:
Keep up the great work providing financial education for the masses. While I don’t agree with all your points of view, I do appreciate the stimulating discussions that your readers (and you) engage in.
I found your site quite by accident (a link from Money Wizard and The Money Habit … bless the wonders of the internet) about a month ago, and have been a voracious reader/student ever since. My first reply though.
I’m curious as to your POV on my early retirement/ROTH conversion scenario, which I haven’t seen any of your other readers post on yet.
My spouse is early retiree, and will start receiving a $50K/yr pension this year, and I’m planning to early retire from corp america in 5 years. We have low 7 figures in cash/stock, $700K in home equity, $1M in combined 401K/403b/IRA accounts. 2 kids heading off to college in 5 years (hence the 5 year time horizon to retire), and their college fund is not included in data above. We live in California now, and we are in the 33% tax bracket. After retirement, I’m thinking we should move to Nevada for ~ 10 years, (cheaper housing, LCOL and no state taxes), and implement a ROTH conversion strategy on our $1M retirement accounts, by using our savings to pay the 25% federal tax rate. I think I can covert all our retirement money to ROTH for ~ 25% taxes within the 10 years, then move back to California (in a lower cost area than the Bay Area) where my kids will likely settle down for work and family. In my mind and on paper, that would give us a 7 figure retirement account with no RMD’s for us or our kids (if inherited) with tax-free assets over a long term horizon.
This ROTH conversion strategy has been recommended by a couple different advisors, but I wanted to check with you and the other smart financial wizards in your community, to see if this strategy is too good to be true.
Would welcome any questions and/or suggestions.
Thanks and keep up the great articles.
Triple-Nickels (5×55)
Hello Triple-Nickels,
Many Roth IRA rule/benefit changes have been proposed by Obama the last two years with bipartisan support (stretch rule and instituting a RMD for Roth IRA to name a few). As long as conversions are available in 5 years I still think this is a great strategy but I would be shocked if the rules for Roth IRAs don’t change in the near future. Will existing Roth IRA accounts be grandfathered? Will rule changes focus on Roth IRA holders with +100K balances (as has already been proposed)? I would follow Michael Kitces blog for better info on these issues. FS’s articles appear to be evolving but are lacking rigorous research and factual (more often naive opinion based) information. Good luck
Google: Using Systematic Partial Roth IRA Conversions And Recharacterizations To Fill The Lower Tax Bracket Buckets
One caveat about your outlined strategy – the unpredictability of you and your spouse’s health. From your post, I’m not sure what your current ages are (55)? I acknowledge that a move at age 60 is more than doable (many friends of mine have and are currently doing this) but a move back at 70 is a whole different animal. I’ve know more than a few couples that moved out of state to execute similar strategies with the hope of returning some day. Invariably, health problems will arise unexpectedly leaving you alone with unfinished plans once meant for two. You can’t really plan for it but your health should at least be considered when making big plans for your future.
Thanks FS and Lee for your responses.
FS: thanks for the referral blog to keep up on the latest political/governmental changes re: ROTH IRAs. Will post here if anything interesting from Michael Kitces blog. I really appreciate all that you’re doing here with your blog. One more request, if you don’t already have this feature available (I may have missed it, as I’m still furiously catching up on the past many years since you started) … could you please add link that simply organizes the latest comments from you or your readers (matched to the blog they’re commenting to), so if a reader wanted to simply scan all the latest comments, then they could peruse through that way. I see you have most commented blogs links on the right panel, but that still doesn’t allow to see all the latest comments. Just a thought.
Lee: Good food for thought about missing out on the best laid plans due to unforeseen health issues arising. Here’s some additional background on SO and me: He’s 55 this year (hence the pension start), I’m 50 and we’re both in reasonably good health. We have longevity in our genes (grandparents and parents around until ~ 80s and 90s). Plan is just to move for ~ 10 years to NV, long enough to maximize no-state-tax benefits, and should be moving back to Calif around 65-70 years old. However, if what FS says could be true (government changes ROTH rules and benefits), then may have to rethink my plans. Luckily, I’m planning 5 years in advance for ER, so have a bit of time to see what the “new administration” does over the next 4 years.
Thanks again.
Triple-Nickels
Sam,
You forgot another couple of points for putting money in a Roth.
a) Your income will be fairly decent and could cause you to pay more in taxes from your SS check.
b) A Roth allows you to ignore tax consequences when making decisions for purchasing items or having to pay for something such as medical expenses (obviously if you haven’t contributed to an HSA).
c) You are NEVER required to take the money out of the Roth, thus it can build before having to do the RMD thing necessary for all pre-tax accounts by the time you hit 70 1/2. So if you don’t want or need to cash out some of it, you don’t have to.
Well, good posts again. Good to hear the other side. If you bought NFLX or another stock, like myself at $3 split adjusted in your Roth IRA. Then a Roth really is better. Not for most people though. I think a Roth is FANTASTIC for Warren Buffet style stock investors. If you buy and hold for decades–for instance even both Berkshire Hathaway 20 years ago (well I don’t think the Roth existed then) and kept in a Roth–the hundreds of thousands of gain would be tax free. Again, most people aren’t going to do that.
I like the passion in your articles.
I’m already maxing my 401k, and am above the level for contributing to Roth IRA, but I’m doing back door contributions. I look at this as the opportunity for tax-free growth somewhere, otherwise I’m getting taxed on it somewhere.
Where does this fall for you?
If you are already maxing out your 401k, if you can do a backdoor, then why not I say. You’re doing tax diversification strategy.
What about saving for a house or something? Any after-tax needs?
Check out:
Invest Or Paydown Debt: Implement FS-DAIR
Invest In My 401k Or Save For a House Downpayment?
You are assuming the the tax percentage will be the same thirty years from now. I highly doubt that. I’d rather pay 28% now than maybe 50% later.
The government thanks you for your up front contribution to help our great nation.
It is great you think your taxes will go up to 50%, or you’ll make so much more in retirement. Optimism is a good thing!
See if you are on track: The Average Net Worth For The Above Average Person
Susan,
If you think stocks are peaking, you could sell covered calls on them for much higher income than CD’s, at least until the new Department of Labor rules prohibit that in many IRA accounts. You see the government thinks you’re too stupid to manage your investments, especially if your broker offers educational materials, blogs, seminars, etc., because those offerings would then be considered advice, which you could claim was bad fiduciary advice if you didn’t earn enough money. So be ready to change your IRA broker, or move funds from your Roth to a taxable account if you decide to trade options.
Current political decisions make passive savers, such as CD buyers, the losers in favor of the big banks and equity investors. It’s called QE and ZIRP, and is a major factor in increasing “income inequality.”
Thanks K-man.
Thankfully I did not panic and did not touch my other mutual fund investments after 2008, did not sell (basically, I am lazy and fearful so I just buy and hold). Like everyone else, I lost about half of the money “on paper” after 2008. Yes, the market came back. As you said, no one has a crystal ball. Yet I feel that I will buying at the top of the market right now in the Roth, and since I’m invested in stocks in my other IRA, I am not sure what to do with the Roth. None of the conservative investments seem that appealing. If/when interest rates go up, then bonds will (ostensibly) go down.
I miss the old days when you could get a decent return in a money market fund. ;-) I may just put the Roth money into an IRA CD for 6, 9 or 12 months and see what happens.
I have 52K in a Roth IRA that I was afraid to invest in anything risky after 2008 (yes, in retrospect I now realize that the crash was a buying opportunity). I have other money in a Traditional IRA (I am self employed for the last 22 years) invested in various stock and bond mutual funds.
My Roth IRA has been sitting in a money market fund earning nothing, and everything I read is that we are on the cusp of another huge stock market crash, stocks are currently very expensive and I don’t have time to actively manage my investments, nor do I want to trust a “financial expert” and pay him 1% of my returns. It seems we are all gambling our money, hoping that the stock market average returns of 8% will continue ad infinitum (recent articles indicate this is wishful thinking). Now I am trying to decide if I should put more money into that Roth IRA and if so, where to invest it. In a CD earning 1.25% for a year? I see myself working for another 10 years (I am 55 this year)…am looking for advice on how to conservatively invest the Roth IRA money (at Fidelity) and NOT lose principal.
The low interest rates for the last 8 years are certainly not helping us 50-somethings trying to plan safely for retirement.
I’ll offer my two cents, for what it’s worth.
You really need to identify your investment horizon first. If you need 100% of that money, or a certain portion of that money, within the next 5 years then don’t put it in the stock market. I’ll base the remaining discussion under the assumption that you’re planning to invest most of it beyond the next few years.
I would continue being part in stock funds and part in fixed income funds (bonds, real estate, CDs, other). The percentage mix is up to you. I personally am mostly in stocks right now. Are the prices relatively high right now? Yes. Are they higher than they should be? Possibly. Does that mean you shouldn’t buy stocks? Definitely not.
I know some really bright people who work in finance that thought stocks were overvalued in 2012. These people missed out on some huge returns as they stayed on the sidelines for the last 3-4 years. While no one knows for sure what the next 10 years will bring, stocks have rarely lost money over longer horizons (think 10+ years) and very frequently delivered large gains.
Even people who got into the market in mid-2007, arguably the worst possible time in recent history, are looking good now provided that they didn’t abandon their investments when the market dropped. If you’re going to panic and sell everything if some of your holdings drop by 10%, 20%, possibly close to 50%, then you should consider finding things that are relatively safe and having more limited stock market exposure. If you can tolerate it and accept that it’ll be best in the long-run, then enjoy making more than 1-2% per year.
Hi Sam,
Here’s a reason why I believe that contributing to a Roth IRA could be useful for me. This won’t be relevant for most of your readers, but it might work for someone in situation similar to mine.
I have had Roth IRA money sitting in a savings account at my credit union for about 8-10 years now, earning next to nothing, and finally rolled it over to an online investment account this year. Since it’s a rollover from an existing account it has “aged” and is not subject to the same withdrawal penalties as a new account.
I just passed the 59.5 year mark, so if I need to withdraw any of the funds from this account I can do so without penalty.
I have savings goals for 5-10 years from now that have nothing to do with retirement and need a place to stash money, while also needing a place for an emergency fund.
If I am willing to accept the same investment risk with money that I intend to use in 5-10 years as I am with retirement funds in my 401k, wouldn’t this Roth IRA be a good vehicle for me to stash up to $6500/yr. in savings that has higher potential for earnings than say a savings account or CD, plus the earnings will be federal tax-free, plus I can access the money in a true emergency if I need to?
Am I deluding myself, or does this scenario have potential (for me, and a small handful of people in a situation similar to mine)?
I’m not sure the author realizes the primary benefit of a Roth IRA, because (as the author pointed out) it offers little benefit if trying to pay lower tax on the $5,500 annual contribution.
The core benefit of a Roth IRA or 401(k) is to completely avoid paying ANY tax on the gains made in the Roth, which, if managed well and over a period of a few decades, will exceed the principal contributions. So if you’ve contributed $50,000 to your Roth over a lifetime and had a $70,000 gain on those investments, you’ll be able to withdraw $120,000 in retirement, only having paid a ~25% tax bracket on the $50k as you earned it (meaning an effective 10.4% tax on the whole lot). The benefit relies entirely on making a large return with your Roth investments.
The benefit of a traditional IRA or 401(k) is that you defer tax on the money used for contributions (typically from a 25% tax bracket)… until you withdraw them PLUS your returns in retirement (at whatever the tax bracket is then). If you withdraw a “typical” amount in retirement, you’ll probably be paying around an effective 10-15% on the whole lot. Since contributions were pre-tax, some believe that gives people essentially “25% more contribution power,” so they can contribute more along the way, therefore leading to higher growth and more available in retirement than if that contribution money had been taxed all along. That works on paper, but not so much in reality.
As you can see, the taxation is pretty close either way – there’s no clear winner, and the one that will be marginally better for you is dependent on factors beyond your control… namely: how your investments perform over time, and how congress adjusts taxation over time. Roth IRAs are probably the best bet for a young person earning under the 25% tax bracket who plans to earn lots more in a career one day… but there’s no guarantee it’s better for them, and they’re the ones least able/interested to contribute to it. That’s why this new MyRA plan is actually a pretty good idea… it’s aimed at getting young low earners contributing to a Roth IRA.
And oh, if you are that young low earner, the govt currently has what is essentially a “contribution match” program… Google “Savers Credit” to find out more.
Basically, you can get a 50% match on the first $2,000 you invest each year if you’re earning around $7K to $17k, or a 10% match if earning less than $30k. The “match” is actually in the form of a reduction in the taxes you owe at the end of the year…. but still, it’s extra money in your pocket just for contributing to your own savings.
Keep in mind on that magical 1040 that a fair amount of income is exempted from taxes, between standard deductions and your personal exemption. This provides further benefit to the Traditional 401(k) or Traditional IRA model.
So in a typical retirement scenario where there is no earned income, I think (but am not sure… I’m sure someone will correct me) that the first $10K or so of “ordinary income” out of a traditional 401(k) or IRA distribution will be exempt from taxes. So that’s (very roughly) $10K a year that went into the Traditional 401k tax free, and essentially comes back out of the 401k tax free — every year that you take retirement distributions!
I realize this is an old article but obviously still being commented on late this year, so figured I’d give my feedback.
The article says “As you can see from the chart, if you make over $129,000 as an individual or $191,000 as a married couple, you can no longer contribute the maximum $5,500 to your Roth IRA.” But it does not point out that you also cannot contribute to a tax-deferred traditional IRA either. You can, however, utilize a backdoor Roth for tax benefits, whereas a traditional IRA would be after-tax and any gains also taxable.
Second, the article fails to mention that if you do contribute to a Trad IRA for X years and decide you want to switch to a Roth IRA at some point down the road, you’ll be paying all that tax and get taxed on the gains when you convert. Of course, if you decide not to convert and just want to start Roth contributions, then you don’t get the full tax advantage because of the pro rata rule against the sum in your traditional IRA.
Third, no mention of the other benefit with a Roth: that you’re allowed to withdraw the base tax free for any reason. For some first-time homebuyers this could prove beneficial. I wouldn’t advocate for raiding your retirement funds for any reason but every situation is unique and Traditional IRAs don’t have this benefit.
So folks that are hesitant to contribute to any retirement and would feel safer with the Roth contribution-base cushion, high income earners who can take advantage of the backdoor, or people that expect to be in a higher tax bracket at retirement than they are now, would all benefit from a Roth more than a Traditional IRA.
I wholeheartedly agree. A backdoor roth or even better a mega backdoor roth provide an amazing opportunity to invest post-tax money for massive tax free withdrawals in the future. The thing everyone seems to forget about 401k withdrawals, it’s treated as ordinary income. I’ve been taking advantage of the mega backdoor roth for years. After maxing out my pre-tax account why not get future tax benefits on post-tax money that would otherwise get taxed annually in a taxable account for the next 20-40 years. The IRS limit is 53K (under 50 years old) or 59K (over 50 years old). Post-tax money converted into a Roth costs the same in upfront tax as investing the same money in a taxable account but with no tax on the earnings at withdrawal – AMAZING DEAL! If you can’t do the mega backdoor roth do the regular backdoor roth. If you can’t do it for yourself, do it for your young and dumb children. Assuming a 7% return, your Roth investment would double every 10 years (single deposit of 6K equals 96K in 40 years). There are so many benefits to contributing to a Roth IRA, my favorite being its tax-free at withdrawal and a close second being that at anytime after 5 years of ownership you can withdrawal the principle penalty free.
Tom, an internet article suggests that at anytime after one minute “of ownership you can withdrawal the principle penalty free.” Can you check with your source about this?
Right you are my friend. I got so excited about why I love Roth IRA’s as an investment vehicle I confused myself about the 5 year rule for qualified distributions versus original principal contributions (there are actually two 5 year rules for Roth IRAs). You can remove your principal contribution at anytime but must keep an accurate record of the contribution amounts as you will be mixing contributions and gains together over time. Most brokerage accounts will keep a record of contribution amounts and date of contribution so it shouldn’t be a problem unless you move money to a new brokerage account throughout the life of the IRA.
As an aside, not knowing the original contribution amount gifted to children/grandchildren could be a blessing in disguise in preventing them from removing the principal before 59.5 years old. I’ve encouraged my own parents to gift grandchildren Roth IRA money instead of straight cash as a means of teaching and preparing them better for retirement.
I answer yes to 1, 2, and possibly 3 (post-army retirement or with my future wifes income pre-army retirement).
My current finance plan already maxes out my traditional TSP (401k) and maxes out my Roth IRA. My pre-TSP contribution deduction tax bracket is 25%. In the next year or so it will increase to 28% pre-TSP contribution deduction. With this wage increase, the post-TSP contribution deduction will bring it back down to 25% although I don’t need the full 18K to do this.
I am in a 5-year finance plan review and what is throwing me off is the new ROTH TSP (401K). I have not yet contributed to this option.
If I apply your principles I think you would tell me to keep contributing to my traditional TSP because I should not pay taxes now…but as a soon to be yes to question 2 and a likely yes to question 3, who already maxes out my ROTH IRA it seems I should take advantage of this new Roth TSP while I am still under 129K/191K income.
Does the 129K/191K ROTH stop contribution apply to ROTH TSP? I am guessing it does not because TSP is an employer plan and I am not aware of any max income for employer plan contributions.
Logic of a new plan to implement for next 5 years;
1. Contribute amounted needed to Traditional TSP to keep me in the 25% tax bracket (~8K).
2. Contribute the remainder (~10K) to the ROTH TSP.
If there is a 129K/191K ROTH stop contribution apply to ROTH TSP.
3. Then go back to contributing max to Traditional TSP.
Thoughts from the Financial Samurai?
Hi FS!
Great article and awesome website. I’m glad I found it and will be reading your various other posts to gain more knowledge.
I’m in my mid-twenties and have just had the opportunity to start a 401(k) and making around 45,000k.
From what I’ve been reading, a lot of people have recommended those in my stage of life to max out employer contribution match, then Roth IRA, AND then Traditional IRA.
Reason being is that I’d be making more money in the future and will be at a higher tax bracket.
I know you’re for deferring paying taxes for as long as possible, but given that no one knows what the tax rates are going to be 30 years from now, would it be smart to diversify between ROTH and Traditional?
If you were in my position, what would you do?
Thanks so much for shedding light for us on this topic.
Sincerely,
Peter
Hi Sam, I appreciate all of your posts! As a college student about to graduate, your articles have helped me so much as I plan to enter the “real world”.
My question is, do you have an opinion on contributing to a Roth 401K vs Traditional 401K? I am going to be starting at a Big 4 accounting firm making $55,000 and was planning on contributing the maximum to my Roth 401K with the expectation that my salary will increase to over $100,000 by age 30. Would maxing out the Traditional 401K combined with maxing out a Roth IRA make more sense?
Hi Mike, I would max out the 401k first, then contribute to a Roth IRA. Stay away from the tax man as long as possible! You don’t know the future except for what you do with your money now.
Hi Mike — in your case, I’d suggest using the Roth 401k in your first several years at the company. Once you start breaking into the 28% tax bracket, you may want to consider putting those excess earnings into the traditional 401k to keep all of your income in the 25% bracket.
It’s fairly marginal, though — we’re talking 3% on a couple thousand dollars each year, but as you earn more and more over that 25% bracket, it’ll save you more and more.
You’ll be happy when you’re in that high earnings bracket that you used the Roth while it was of most benefit to you.
I’m betting Sam doesn’t have any children…
Perhaps the single easiest way to setup your kids for retirement is establishing Roth IRAs for each child early in life. Early meaning age 8 or thereabouts. The only restriction is the contributions have to be earned income, so it helps to have a family business or some other legitimate means of funding it.
Federal and state taxes are effectively zero on the income needed to max out the Roth. Throw in $5,500 annually for ten years (Age 8 through Age 17). Plug it into an investment calculator with conservative returns (6-8%) for 50 years.
Stand back in amazement at the astounding returns. Congratulations – you’ve added another multi-millionaire to the family without anyone putting another penny into the Roth account over the next five decades.
@Ken – income is not a barrier to contributing to a Roth IRA. Anyone can do it no matter the income level. If your income is above the direct contribution limit then just do a “backdoor” contribution. First contribute to a traditional (non-tax deductible) IRA, then immediately convert the money to a Roth IRA (your broker will have a special form for this).
NOTE: when doing this there could be tax implications if you have any tax-deductible IRA’s. If so then you have to consider this total amount when doing the conversion. If you don’t have any tax-deductible IRA’s then the conversion is a slam-dunk!
Interesting article. I’m a tweener, maxing the 401k, maxing a ROTH IRA and saving additional income. I’ve only recently been able to save this much after paying off student loans and having the GF move in. It’ll probably only be a couple more years until my income phases me out of the ROTH so it won’t be a very big piece of my pie. I’m thinking less than $50k will be put into the account.
I don’t agree. First, you are assuming our government will be less corrupt in 20 or 30 years, and so paying taxes then will be more rewarding. That argument doesn’t hold water.
Secondly, those of us with kids and a mortgage have several write-offs. In retirement, I won’t have kids and I won’t have a mortgage. I also benefit from being able to file jointly. In retirement it is likely that I or my wife will be filing as single at some point. The RMD’s and inherited IRA’s will be less desirable. A Roth IRA makes the most sense for flexibility in retirement.
I would like to see his or her response to this. This is my thought process as well.
You fail to mention that people that make of 129K can still put the max into the IRA by using a loop hole. People can fund the 5500 of after tax dollars into a traditional IRA and then convert it into their Roth IRA.
Here’s my article: Is A Back Door Roth IRA A Good Move For High Income Earners?
Some of this is luck. I purchased AAPL in 2000 for my Roth IRA. All that growth will be tax free. (Unless the laws change.)
I’m in my mid-60s. At 70 1/2 I’ll need to begin RMD withdrawals from my IRA. I considered converting some of my IRA to Roth IRA annually for the next five years because I expect my heirs to be in a higher tax bracket than me. However, my calculations show break-even (for me) at age 93. Might be best to do nothing.
OTOH, if congress pushes thru the idea requiring inherited IRAs to be distributed within 5 years, conversions will significantly reduce future taxes.
Hello, if someone is in Chapter 13 bankrupcy but is allowed in contributing to a Roth IRA through their employer, what kind of twist does that bring to it all? Is it better in BK to change to a pre-tax plan if you actually owe taxes as part of the bankrupcy? I’m interested to hear your thoughts…Any replys are welcome
The Roth can be a very helpful vehicle for GREATLY reducing AGI and therefore taxes after age 70 if you max out your SS by delaying it. If you are 55 or older and have not filed for SS yet, you MUST read this white paper ; If you are much younger, read it anyway and be informed and maybe help YOUR OWN parents make the right decision. Too many of the articles here assume you are too old to care or do anything in life at 70. I got news for you..if you die before then, well you’re dead, so it doesn’t matter as long as you took care of your responsibilities. But planning around early death is seriously negative thinking! But if you’re alive and vibrant, it will matter a GREAT DEAL. 70 is nothing if you’ve lived a healthy life, and you may have to provide for you AND a spouse for 15 -20 years PAST 70. You younger people REALLY have a warped image of “old” age.
When considering a Roth IRA, I’ve always wondered what the folks in Washington will do if they replaced the income tax with a national sales tax. Taxing at the point of spending money instead of making money could be double taxation for money in a Roth. Would Washington offer some sort of credit? Have you heard anything from those who are for a flat sales tax?
Roth is FAR superior to 401k (after company match is met), but holy crap, your tax change thought scares me!
This is a fine example of one of the biggest risks in a Roth. Is it possible the government could make some radical tax change that diminishes the benefit — yes. Is it likely — no. Many billions of dollars representing millions of people are in Roth accounts, and it would be a violation of good faith for congress to alter the expected overall tax burden. But if any “crisis” happens before you retire, you had better believe they’d be willing to harm Roth benefits alongside others. In other words, if the government needs to raise revenue in the future, I think they’ll try to do in as fair and equally distributed way as possible, and that includes harming all retirement accounts equally (or not at all).
Also consider this…. currently, I believe all states follow Federal income tax treatment/benefits of Roth accounts. But it doesn’t have to stay that way…. so yes, if you live in a wonky state that decides it “needs” to tax income earnings on Roth accounts upon distribution, that could also happen.
I know this is pretty much covered in the rules above, but I don’t think the point was made strong enough…
I agree with the insinuation that the deferral of taxes is best, but I think that relative to the general public there is a higher percent chance that a financial blog reader SHOULD be contributing to a Roth or a “backdoor” Roth IRA.
Given:
1) You’ve maxed out traditional (non-Roth) 401k
2) Your income level is too high to be eligible for a traditional deductible IRA
A high percentage of financial blog readers fulfill these two requirements. In essence, you’ve already lost the ability to defer tax so why not stuff some cash where it can grow tax-free?
Definitely agree with you here. Better to have some cash grow tax free if you’re not able to get a deduction with a traditional IRA.
I wish I could contribute to a Traditional IRA, but due to MAGI income limits (and due to the fact that I do have a 401k to contribute to at work), I cannot.
If you have a 401k to contribute to at work, there’s a fairly low income threshold for being ALSO able to contribute to a traditional IRA. (MAGI below $61k for individuals, $98k for married couple). For a lot of folks, the Traditional IRA’s not an option. When that’s the case, the Roth is often the best of the remaining choices.
https://www.irs.gov/Retirement-Plans/2015-IRA-Deduction-Limits-Effect-of-Modified-AGI-on-Deduction-if-You-Are-Covered-by-a-Retirement-Plan-at-Work
Since the Roth income limits are much higher, I contribute to a Roth IRA simply because it provides tax advantages compared to investing in a taxable account. (i.e. – avoiding capital gains and taxes on dividends.) I can also rebalance my portfolio within a Roth to bring my investments back into my asset allocation, without suffering capital gains. (So, I suppose there’s an added benefit of being able to more efficiently rebalance.)
The idea that contributing to a Roth somehow results in more taxes paid is not true for me — probably not for a lot of people.
I’m in the same boat as you are. I too am maxing my 401K then maxing a Roth. I’m hedging my bets and figure it’s better than spending the dough on stuff I don’t need.
For the same reason as you had, I chose a Roth over a taxable account since rebalancing would not incur taxes, and a Roth gives me flexibility when planning distributions after retirement. I am already in a fairly high tax bracket so there’s no reason to incur more unnecessarily.
Once my mortgage is paid off I expect to contribute that extra money to a taxable account, whose investments will be chosen with an eye towards tax efficiency.
Somewhere soon thereafter I hope to retire!
I presume you also don’t propose that people take advantage of the new clarity around converting after-tax 401k contributions to Roth IRA? I make $150k a year and my wage-related income will probably be about that amount adjusted to inflation for the rest of my career and it has been for the last several years as well. So I have a bit extra money that I’ve been thinking about dumping in some after-tax 401k contributions to convert in-plan immediately following each pay period (my plan allows this)
Each year I max-out my 401k Pre-Tax, then max out my Roth with Backdoor contribution. Although I have a very good 401k plan with Vanguard with really low institutional fees (negotiated by my great employer) on most funds, I can’t trade in individual securities. I can do so in my Roth IRA and have made $45,000 profit in the past year alone doing this. If I was trading that in a regular after-tax account, I’d owe short-term capital gains. Instead, I get a tax-deferral.
I live in California.
I have little over 600 K in traditional IRA, investing 20% (1200 per month) of my salary to my job 401 k (just started this year with a new job). I also have a bank account with little over 150 K in it that doing nothing right now bc of interest rates are so low. I’ve got about 10 years till retirement. Would it be smart to start taking max amount (12,000 for me and my wife) every year for the next 10 years from my bank (after tax money) and invest them into the Roth? Thank you very much for the reply.
your earnings are tax free. For someone in their twenties, it makes sense to contribute to a Roth since ALL OF YOUR EARNINGS will be tax free. This is the advantage a Roth provides, even if you’re paying taxes initially.
Thank you for posting this!
Personal Finance 101 would recommend utilizing Roth accounts to protect taxable proceeds upon sale of the equity.
I would much rather pay income tax today on $5,500 than 20-50 years from now when the account is worth $1,000,000’s.
Except that you would have had more money in your trad. IRA since it is pre-tax (if eligible for the IRA tax deductions). If you are in your 20’s with many years of compounding that extra money, this makes the IRA a very strong choice.
Roth could be a good vehicle for back-up savings in your 30s+ if you expect to make more money in the future (like if you are getting a PhD). You can withdraw the money you put in at any time, without adding to your taxes when you are in a higher bracket.
Wrong, the contribution limits for both the trad and Roth IRA’s are exactly the same, so you are actually able to contribute LESS spending power into a trad IRA than into a Roth. You would have the delta outside of your trad IRA to invest in other ways, however.
I have a couple problems with this article.
1) I would imagine items 2 and 3 on your list encompass a pretty large percentage of the population; thus, making the Roth a smart move for what is likely a majority of people.
2) You still downplay the benefits of a Roth. Even for the people not encompassed by your points 2 and 3, there exist many favorable attributes of a Roth over a Traditional. The flexibility to withdraw and contribute at various stages in life is far greater.
3) It’s not a bad idea to have a traditional and a Roth because it hedges against uncertainty in the future. Although some of us may pretend to know what the tax landscape of the country will be in 20+ years, we don’t.
That’s fine. And also, I don’t think you have to justify your reasons for contributing to a Roth IRA. First of all, America needs more contributing tax payers. Second of all, contributing is better than not contributing.
I’ve just chosen not to contribute and to defer taxes as much as possible. Everybody has their own decision. At the end of the day, look at your net worth for your age, and see if you are on track. If you are not on track, then you’ve got to change.
Well, the personal decision to pursue a phd has caused #2 on your list to make it definitely seem justified to have a Roth in my case. That is, it’s saving me taxes. However, my general point is that the Roth probably is good for a large percentage of individuals.
Question: Is your blog geared specifically towards people in top 1% (or top 5%) of the wealth and/or income distribution, because if it is targeted at a very specific audience I could see some of it making good sense? My main issue is that the article seems to be making a lot of general statements that are only true in specific circumstances.
Ahhhh, getting a PhD explains so much now. Thanks for sharing! I considered a PhD in Communications, and decided to pass at the end b/c of the stark reality that it would be difficult to find a good professor job and tenure at a decent institution. I wasn’t smart enough. Also, as you know, the earnings during the PhD period is quite low.
Have a read of this post: Should I Get A PhD? Life After The Private Sector, and let me know your thoughts! https://www.financialsamurai.com/life-after-the-private-sector-should-i-get-a-phd/
My blog is targeted towards people who want to achieve financial freedom sooner, rather than later with the ultimate goal of helping people achieve happiness. Hence, those who are getting a PhD are probably not my target audience since a PhD is a long detour, unless they are getting a physician/medical PhD.
I mean, I’m pursuing a PhD because I’ve always wanted to work in academia and it’s really the only way to get there; however, I’d be lying if I said I would pursue one regardless of the expected monetary outcome.
Am I excluded from the target audience on the basis that I have more than one variable (money) that enter into my life decision making? Or, am I still included because money enters into the equation for me, personally?
It depends on what you’re looking for. I like to cut through money’s mysteries because the media has done a great job in manipulating the public. And if you look who writes mass media articles, they are by journalists who have never worked in finance, haven’t reached financial freedom, or write things they don’t understand e.g. write about housing when they down own a home.
FS is a place to broaden people’s minds and allow people to think for their own.
Everybody is always so enthusiastic about their careers and education in the beginning. Then, once they get into the real world, things change. Energy changes. Life changes. We all grow older.
How older are you, and how many years did you work before pursuing your PhD?
There hasn’t been a discussion to my knowledge of a backdoor Roth. I am in the situation where I cannot invest in a traditional IRA because of my income level. I max out my 401(k)and then do a backdoor Roth. I had a traditional IRA through Vanguard and converted that to my active 401(k) at my current employer. My current 401(k) allows me to set up a brokerage account option that I pay $100 a year for so that I can invest in anything at super low expense ratios. I wouldn’t recommend someone moving their Vanguard IRA to an active 401(k) unless they have great low expense ratio options. I now have only a Roth IRA with Vanguard and my 401(k) with my employer. This allows me to convert my traditional IRA investment to a Roth IRA without paying any conversion taxes on my traditional IRA gains. Doing a backdoor Roth is a great option for high income people as you don’t pay taxes on this investment when you retire and start pulling this money out.
I would get a second opinion on this. If it sounds too good to be true, it probably is. You don’t want to get nailed on this and end up losing all of your retirement savings to penalties assessed in an audit.
A backdoor Roth conversion is a legitimate loophole. When you do this, you generally want to immediately convert the account, so that you do not build up taxable investment gains before converting. (taxes are owed on gains from the account, but since you aren’t eligible for a Roth, you are also not eligible for a pre-tax contribution. Your after-tax contribution is not taxed again) However, if you already have other traditional IRA accounts, then the conversion will take into consideration all IRA accounts together, not just your backdoor contribution. (essentially, the IRS treats it as if you have converted proportionally from each account you have)
However, this rule does not apply to traditional 401(k) accounts. So one way to enable yourself to take advantage of the conversion without being subject to taxes on the gains in your other accounts is to roll over your IRA into your current employer’s 401(k). (Your employer may or may not allow this. Generally, it is only allowed for active employees–but call your plan’s custodian and ask, to be sure) Once you have all your pre-tax money in a 401(k), then you can pull this trick without worry or tax consequences.
Disclosure: I am not a tax professional, but I have utilized this tactic in the past. You should ask your accountant or tax preparer, as they are the only ones other than yourself who know your specific situation.
Yes! This is what I do as well. It took me a long time to research it to make sure I had considered everything. It is far better to put money in a Roth IRA than keep it in a non-deductible IRA (earnings taxed upon withdrawal- finally found information that the contributions wouldn’t be double-taxed) or pay taxes on gains in a brokerage account.
Especially since the Roth IRA contributed amount can be withdrawn at any time after the incubation period- which means that it is a back-up savings account that won’t be taxed. And the first-time homebuyer benefit of either IRA is great for those people living in the cities with >$1M homes, if we can ever afford it.
Wow- thanks for the clarification!
“You can withdraw contributions (not backdoor conversions) you made to your Roth IRA anytime, tax- and penalty-free.” – See more at: https://www.financialsamurai.com/is-a-backdoor-roth-ira-for-high-income-earners-a-good-move/#sthash.OvtMI86K.dpuf
One advantage is that funds in a Roth IRA will pass to heirs tax free.
Yes, that’s because the funds in a Roth IRA were already taxed by the person who contributed them. It’s not much different than inheriting a savings account in a way. There is a slight benefit in that all of the earnings in the IRA are treated (tax free) as though the original owner had decided to cash out. But they could have done that anyway just before dying with the same tax implications (which is probably why this is allowed, to prevent a panic when grandpa’s on his deathbed).
I guess one benefit would be if you were an heir under the qualified distribution age, and the person who died was also under the qualified distribution age, the earnings would be released tax free before they would ordinarily be qualified. It’d be somewhat unfair to force a tax burden on a middle-class heir, so this “fringe benefit” is probably extended to them for that reason, and probably doesn’t apply in most cases where large earnings apply (i.e. an old IRA account with lots of earnings probably belonged to an old person who died).
Mike, there are actually even greater advantages with inherited IRAs and Roth IRAs.
The beneficiary only needs to withdraw the annual RMD based on their age, leaving the remainder to grow tax-free.
If you withdrew everything from an inherited Roth IRA, you’d owe no immediate taxes, but all interest and dividends earned would be taxed annually. By leaving the money in the inherited Roth IRA and only drawing the annual RMD, the balance in the Roth remains tax-free.
Look up Ed Slott for detailed books and articles on maximizing income and minimizing taxes on IRAs.
I’ve read most of the posts and am a little confused. I am military and have a traditional TSP account. When the roth was offered I already had a sizeable amount in the traditional account. If I started the roth while lowering my investment into the traditional account wouldn’t I be losing out on the compounding power of the already large balance. It seems contributing more to the traditional would be the better option so I could make the most on the already accrued amount. If I was just starting out or was maxing out the traditional then maybe I’d go with the roth.
Rick,
Your choice of future investments will not impact the compounding of the investments you have today. Ignoring the tax differences, the two accounts will add up to the same amount as if you had continued contributing to the one account.
In reality, the Roth may look smaller if you put the same pre-tax dollars into it (meaning, a reduced after-tax amount) but it will be worth more, because you will pay no taxes on the withdrawal. (and, assuming your tax bracket is the same when you are withdrawing, it would give you the same net money, too, either way)
My argument for the Roth has always been exactly for your situation–nobody knows what the tax situation will be in 20 or 30 years, so the best defense is diversification: having some pre-tax and some post-tax money.
Wow, I’m still working to digest all this information and some of it is not sinking in.
I already max out my 401K and behind in retirement savings for early 40’s., I just tip over into the 28% bracket since I’m single. I’ve always thought maxing out my Roth was the next smart financial move since I have to pay 28% on that money anyway as there is no other way to shelter it as far as I know. And my returns are tax free. How can the IRS cream me later? I thought my tax liability is paid in full on the 5.5K. Actually this year is the first year of my life that I can’t contribute the max, as I will be in the phase out range.
Your income tax bracket is a tweener. You’ll probably be fine. I just don’t like paying taxes up front to this incredibly wasteful and disfunctional government if I don’t have to.
Great job maxing out your 401k! Here’s the latest 401k article for 2015.
thank you for your response and for your blog. I’m a new reader and am enjoying thus far.
I love the combination of this post and the “disadvantages” post. Gives a good two directions approach to your advice regarding “to ROTH or not to ROTH”. I hope to read more of your articles in the future. Sadly I have chosen to ROTH, a little. My employer 401K plan now has a ROTH option they just rolled out in October 2014. I am about 1/3 of the way into my career, and have a high earning spouse, but LOTS of expenses (daycare, investing in a business, mortgage). I am contributing beyond the employer match but see no horizon where I can max out the $17,500. With the high earning spouse younger than me likely working for 3-5 years afters I retire, and the hope that the business will be providing retirement income some $ in ROTH 401(K) makes sense to me. Good Luck to us all!
Wife and I make combined income of 210k /yr . I’m 32 , she’s 28. Wife just changed jobs. Has 15k in old companies 401k. Thinking about either leaving it in the exisitng 401k account (it has lots of options and .5%maintenance costs annually), converting to her existing company 401k (which I don’t like since the options suck and expenses are high), converting to traditional IRA or Roth IRA. If Roth, I get taxed at 28% right off the bat. But I like the idea of tax diversification. Not sure what to do. What makes the most sense?
Tom,
Since you are asking…
Note that, if you convert to Roth, you have to come up with the $4,200 in cash yourself, immediately–if you thought to use some of the $15k for that, then that is considered a withdrawal, and will also be subject to the 10% additional penalty. In fact, what will likely happen is that the 401k will short-change you $4,200 (i.e. withhold the taxes) and you will need to find it, to deposit along with the rest.
Happy thought #2: the .5% maintenance is .5% more than your IRA would charge. I don’t know of a 401(k) with such an advantage in investment options that it is worth that much. If you are generally indexing, then that’s an outright ripoff. (For reference, my very large employer’s fee is .11%)
If you want to diversify your tax treatment (which I do think is a smart thing) I would suggest you start your new contributions into a Roth 401(k) or Roth IRA.
I’m surprised no one has brought up a doctor’s tax situation and the benefits of having a Roth.
I am currently a radiology resident in NYC making ~65k/year for the next few years. Once I graduate, my income will increase 5-fold. I think in this situation, likely for any medical resident, it makes sense to contribute to Roth IRA/401k when in the “low” tax bracket, because they will most likely never again be in this low a bracket again and will undoubtedly contribute to a 401k/IRA during their peak earnings year.
Tax diversification is always a good thing, especially in retirement!
Best use of the Roth is for establishing a retirement account for your children. You can establish a Roth 401k for a child with you as the custodian until they hit 18. Unless your kid’s a super successful child actor or model – chances are his/her meager earnings are not going to be subject to taxes going in and will be tax free coming out. Better yet if you own your business you can expense their earnings as wages and reduce your tax burden as well – obviously you’ve got to have the child do real work (i.e. W2 reportable wages) – but having them star in an advertisement is legitimate work. 60 plus years of compounding…
This has to be the first article I have ever seen daring to go against the Roth IRA and you do bring up some good points. Just as you recommend, I did max out my 401K yearly and then also contributed $500 a month to a Roth IRA from 2000 to 2009 when I retired at age 51 and just let the Roth ride. As I take comfort in knowing I now have $100K or so “supposedly” tax free in the Roth, after reading your post I wonder had I made these contributions to a traditional IRA along with the taxes I paid going the Roth route, what would I have in the traditional IRA account now by having the tax money I paid also compound and gain. To keep it simple and including my state tax rate, $500 + 30% (taxed rate) = $650 a month to a Traditional IRA vs. the $500 I contributed to a Roth, both having the same monthly out of pocket financial weight to me. Something to ponder as now my tax rate is lower than it was all those years and who knows what it will be in the future. I would have liked to have seen this article in the year 2000 when I was trying to make the traditional vs Roth IRA decision. Once again you have written a thought provoking article. Thanks.
Hi Tommy,
Glad you enjoy the other side of the story. The government and the brokerage community are aggressive backers for good reasons. Saving in a Roth is better than not saving at all at least!
Sam
Thanks for the article, Financial Samurai. It really made me look through the reason why I invested in a Roth IRA. Ultimately, I decided that it is still the best for me because I’ll be in a substantially higher tax bracket a few years from now and will only be able to contribute to a non-deductible IRA. For those reasons and for the fact that there are no RMDs, I’ve decided to stay with a Roth for the time being. I wrote about it in more detail on my website.
As far as what Jared said a few comments above about withdrawing contributions, if you only withdraw what you’re receiving in dividends, the overall income generating ability of the Roth portfolio would the same. I go into more detail about this as well on my site.
Thanks again.
Based on my calculations with the following assumptions:
Tax rate, ROI, and income are static, and that the tax savings of a traditional deposit is invested at the same ROI instead of spent.
A Traditional outperforms a Roth starting in year one.
It takes a mere .5% increase in rate of taxation to reverse this trend. If you’re investing in a Roth, you’re essentially assuming that at some point between your investment and your retirement that there will be a .5% increase in your rate of taxation. For a lot of people this actually seems to be a pretty safe bet-particularly those who are young and below their earnings apex. Perhaps not quite as safe a bet for someone nearing retirement age.
Being in Silicon Valley, last year is only the second time in my career I’ve been able to contribute to a Roth IRA. Both times were when I was laid off and unemployed for several months.
Typically, I max out my 401k and make a non-deductible contribution to my traditional IRA. It’s not as nice as a deductible contribution, but at least the gains can compound tax-free.
Holding non-tax-sheltered investments is painful come tax time, but I also keep some of my investments outside my retirement accounts so I’m not completely dependent upon the government giving me my retirement funds when I need them. Tax shelters are nice, but freedom feels better.
Me and my wife have been maxing out our Roth-IRAs the past few years.
Here is our info:
-Both Age 30
-Both expect to retire early 50’s with 60% of average highest 2 years of salary as a lifetime pension benefit (with increases built in to keep up with inflation)
-Currently, $90k combined AGI
-25% Bracket
-No debt, but expect to take on a mortgage over the next couple years
-I max out my employer sponsored HSA (recently decided this should take priority over IRA since HSA contributions reduce FICA taxes; funds can be withdrawn at age 65 for non-medical, making it similar to a Trad IRA…)
-We both max out our Roth IRAs (@ Vanguard) rather than Trad IRA
-No 401k option, but we do have access to 403b/457b (no employer matching)
Given our circumstance, are the 2 reasons below not valid reasons to consider a Roth IRA over a Traditional IRA?
1. Ability to withdraw contributions out at any time, without penalty (vs 10% penalty in traditional IRA; allows flexibility to pull money in the event of opportunity / emergency penalty free; allows us to pull funds in early/mid 50s if we want to supplement other income sources penalty free)
2. Tax diversification (no way to know future tax structures; other sources of retirement income will be taxable; our pension plans will (or should) provide lifetime taxable income)
Hi Jared, with no 401k or 401k matching, maxing out each of your Roth IRAs is not a bad choice. But what about the traditional IRA and what you expect in future income?
At a 25% marginal tax bracket with much limited income upside, I think you’ll be paying lower taxes in retirement.
I would eradicate the notion of withdrawing contributions, b/c that defeats some of the purpose.
What about the new tax laws in 2018. Would you stand by this if they were in the 12% or 22% brackets? This is a very similar situation that I am in now.
I recently set up a Roth IRA for my niece and funded it with $5,500 for 2013. She is graduating college soon, and earned about $6,000 to $9,000 last year from summer and part-time jobs. Depending on whether her prospective employer offers a matching contribution 401-k, and she’s vested this year, and how much of her income is taxable for 2014, will determine whether to add to it for 2014, open a regular IRA, or stick to the 401-k. Is this another good reason to fund a Roth IRA, at least for one year?
I am earning about $70k and have been contributing up to my company’s match to fund a roth 401k. I work in NY. Am I doing it wrong?
I think you are. But, I don’t think it’s bad to pay taxes up front as this is how the country is run.
A Roth is not the end of the world.
Any suggestions on how to get myself out of this hole?
Stop digging and start contributing to a normal 401k instead. I presume you have many years ahead for work?
Yup, I’m in my late 20s, worked at one company (financial services) right out of school, but recently took a pay cut and joined a non-bank to get some work life balance and to get my masters.
I’d like to retire early though, I don’t see myself working into the 60s.
Sam, what are your thoughts on the 403(b)?
The thing that frustrates me most is that my household income exceeds the limit for investing in a traditional IRA. I believe I make a nice income, but it isn’t like I’m sitting on my yacht eating caviar. It just doesn’t feel right that my income is triggering essentially the loss of a retirement benefit.
I guess the implication is that I can “afford” to save for retirement without getting a tax credit for it right now. Tell that to my student loans that I’m diligently working to pay off… someday.
35 years old, Maxing out 401(k) and HSA with annual household income of 275k. Never had IRA or Roth until 2 years ago. Established both and currently contribute annual max to IRA for my wife and I and then immediately convert to Roth, thus producing no tax. This strategy was recommended by a financial advisor. Is this an appropriate use of the two devices?
It’s reasonable since you are maxing out the 401(k) and HSA. I’d also measure your after-tax investments in non 401k/ROTH accounts b/c you want liquidity as well.
Thanks for the quick response! We have about 200k in taxable accounts and contribute approximately 15k a year to those accounts annually as well. New to you webpage and like the content. Thanks for all the great content.
I’m not going to be much help in contributing to these comments- but I sure as hell am learning a ton. As I’m basically understanding it, since my wife and I earn under 90k, we should be maxing out our traditional employer sponsored 401(k) plans first, then the HSA, before we even think about touching a Roth?
You forgot #11.
You can no longer max your 401k because the company you work for states you are a HCE (highly compensated employee) at $115k. Now my 401k contributions are capped at 10%. Unfortunately my wife and I are at the brink of the $191k phase out for Roth contributions!
Your thoughts? I think this post needs a follow-up for those that are over the arbitrary $191k threshold.
Marcus,
You can still recharacterize! It will cost you extra paperwork to do so, but is otherwise painless. You make a non-deductible traditional IRA contribution, recharacterize it to Roth, and pay taxes on it. (wait! You already did! As long as you move quickly, and don’t otherwise invest the money in the meantime, this is at or near $0) and, voila!
Note that this can get tricky if you have other IRA’s (not 401(k)’s) as the taxation will be in proportion to all of your IRA’s, not just the account you recharacterize. But, of course, see your financial professional to be sure.
Very interesting post.
Sometimes difficult to follow the mathematics :)
What do you think about my plan?
I have been working for 12 years, my income gradually increased until it reached a plateau around 280k for the last 5 years. I have other investments also.
I have aprox 500k in 401k and 457 plans (aprox 30k/year) and I did “regular” IRA then converted to Roth IRA (presently around 120k total) , thinking that when I retire I can use the Roth IRA if will need at one point more money for a year and this way my tax will not increase then. It is true , I pay high taxes upfront but I prefer to save as much as I can now and then the money in Roth IRA will grow tax free and when I withdraw I don’t have to pay taxes.
Any thoughts?
Thank you.
If you think you’ll continue to make over $280,000 in retirement, then you made a neutral move.
And if you plan on making less than $280,000 while retired, you can just attribute the extra taxes to patriotism!
Thank you for the reply.
I was thinking a little more about this. I contributed every year to this Roth IRA (traditional and then converting to Roth IRA, pretax money, true, but the conversion didn’t cost me anything, it was done in approximately one year after depositing the money). I created 120k brokerage account that whatever I do with it, I will not pay taxes again on it. It must be better than having that money in a brokerage account that is not Roth? Do I miss something?
Obviously I maxed out my pretax contributions before I did this.
If the opinion is still that is patriotism paying the taxes on it, so be it!
Regarding a regular 401k vs roth 401k, isn’t the main idea choosing between the two determining if your current tax bracket will be higher or lower when you retire? So if you plan to be in the same or higher tax bracket when retiring the roth 401k makes more sense.
I did an example of a gain of 5% annually, contributing $5000/yr, 28% tax rate.
After 10 years:
Contribution (pretax) = 45000
Contribution (aftertax) = 32400
Roth (pretax/aftertax)= 50398.76
Regular (pretax) = 57889.46
Regular (aftertax) =41680.41
Is my analysis wrong?
Active duty military with frequent tax free deployments. Last year in the 15% bracket with 1.9% effective tax rate.
Full contribution to Roth TSP (government/military version of Roth 401k) and full contribution to my wife’s and my Roth IRA. Money is going in barely taxed, growing untaxed, and will be withdrawn untaxed after age 59.5. Plus, TSP has the lowest expense ratios of any index funds around.
If you’re in the US military and getting tax free income, you must capitalize on this! Also, much of military pay is untaxed allowances (housing and food allowances), so even if you’re not getting tax free combat deployments, you’re still in a lower tax bracket that what your income actually is.
Not all of us are in the 39.6% bracket, Sam. :P For some of us peasants at the bottom, the Roth 401k/TSP/IRA is actually a pretty good retirement plan. Thanks for another thought provoking article.
Sounds good to me! And I’m not in the 39.6% bracket either. Totally down with joining half of America! :) I plan to not go back, which is why contributing to a ROTH is out of the question!
I’m in a similar situation as Spencer. I am a married (w/ 1 kid), full time dental student, serving part time in the Air National Guard. Since I’m currently paying zero in taxes, I’m dumping all of my pay and bonus into my TSP Roth. I’m glad I’m not the only one. Once I graduate and start working as a dentist, it’s back to my traditional TSP. :)
Makes sense. What is your current marginal tax rate?
Sam,
The comment sections are the best part of your blogs. You do a great job of presenting a topic with your point of view, but it really helps when you have active commenters with various thoughtful view points.
My conclusion is that from a tax point of view, Roth or 401K are basically a wash if your investments are typical mutual funds (or even index ETFs, which are rare in 401k’s). Income tax rates are at a historic low and I would expect them to move higher going forward. The Roth could be a help there.
The real real advantage of the 401k is more psychological. It’s automated. Contributions are done at a small painless amount out of each paycheck (for most folks), so people of course get accustomed to a certain net pay. So life then is good. You go buy your morning coffee from Starbucks every day, while every two weeks, you are dollar cost averaging into whatever mutual funds your company provides.
IRA’s require more of an active effort to contribute. A zillion life problems seem to pop up, preventing contributions. And of course, IRAs require more thought in investment choice. The average person just doesn’t have the ability to put much research effort into various investments. So…. For average people, 401k’s win!
What about the fact that most of your investments for retirement are in growth and not contributions?
Lets say you are in the 25% tax bracket and you invest $5,500 in a regular ira and $5,500 in a roth ira. It returns an average of 10% (average of the stock market) for 40 years.
Initial Tax savings for regular ira = 5500* .25 * 40 years = 55000
Initial Tax savings for a roth = 0
Both account increase to $2,677,684.96 (I used moneychimp.com online calculator, 5500 annual addition, 40 years to grow, 10% interest rate, compound 1 time a year)
Tax due for the regular ira = 2,677,684.96
Tax due for a roth ira = 0
Lets just assume the tax rate is the same 40 years in the future as it is now, even if you only take out the required minimum distribution and you pay 10% tax (the current lowest tax rate). You will then owe 2,677,684.96 * .1 = $267,768
So in effect you paid $55,000 in roth ira (from the taxes you didnt save at that time) vs paying $267,768 in a regular ira. Even factoring in inflation how is over $200,000 more in your pocket a bad thing?
I dont have an employer match at my work, but me and my wife have been maxing out both our roth ira’s and plan to every year for 40 years. Anything extra will go either in a 401k or extra payments to house
Please let me know if any of my calculations do not sound right.
Your math is flawed.
You have to think in equivalent dollars. In order to contribute 5.5K to a traditional, you need to earn 5.5K. If you earn 5.5K and want to put it in a Roth, you only get to deposit $4,125 (5,500 x (1-25%)).
Now do the same math.
Traditional: 5,500 * 1.1^40 = $248,926
then multiply by equivalent withdrawal tax rate (1-25%)… aftertax equivalent of $186,695
Roth: 4,125 * 1.1^40 = $186,695
The aftertax value on day 1 of retirement is the same in either case. The only way they differ is if your tax rate goes up/down.
I understand your point, but I am actually putting in $5500 in a roth ira, not $4125. Putting in $5500 in a roth is essentially savings more than putting $5500 in a regular ira. Im also in a low tax bracket now so the income tax savings is low right now. Im actually going to convert an old ira into a roth this year at only 15% tax bracket.
To put $5,500 into a ROTH, you must earn about $6,500 at a 15% marginal tax bracket. Hence, it costs you $1,000 to get the equivalent of $5,500 in traditional IRA buying power.
I see that I have failed to sway you from converting to a ROTH. But that’s OK, as this country needs as many tax payers as possible now due to our budget deficit.
I am torn, b/c the reality is I would like EVERYBODY except for my little community to convert to a ROTH to pay more taxes to LOWER the chances tax rates will be raised for the rest of us, and INCREASE the chances that wealth gets distributed to those who don’t pay taxes.
Oh, I also get a $200 tax credit for putting money into a roth since i am under the income. See tax form 8880. So I essentially pay $800 in tax this year and it will grow to $248,925 tax free. Or i could leave it in a regular ira and pay 15% tax on that when I retire. Makes a lot of sense to put it in a traditional says the $36,000 I save in tax this way.
I’ve struggled back and forth with the Roth multiple times. One advantage of the Roth over the 401k or traditional IRA is in a scenario where you happen to make outsized earnings. If your post tax 10,000 contribution into a unicorn stock turns into 150,000 over a period of time, all of that gain is tax free in the Roth. If I put pretax 10,000 into the same unicorn stock, I would save maybe 3000 up front but all of that gain would be taxed when I withdraw.
This is a scenario where the Roth would be great. I’ve read most of the comments in your older Roth article and this one but no one seems to mention this. Did I miss something or is this just common sense to everyone already?
It’s a good point about hitting a super home run. I suggest checking about Distribution strategy bc for a rollover IRA, the entire fund is blind to the IRS. The tax is based on distributions, so if you distribute at a lower amount for lower taxes that is one strategy.
You wouldn’t want to withdraw all $1 million of your IRA at one go for example.
Interesting article about how some people use Roth accounts to shield pre-IPO shares from tax forever.
https://www.forbes.com/sites/deborahljacobs/2012/03/26/why-and-how-congress-should-curb-roth-iras/
I would definitely consider taking a $0 salary for a year if it meant I could load up on privately held shares in a Roth account.
Sam, this is brilliant! Of course, not many of us are sitting on multi-millions.
Hey! great article and timing; I’ve been working on testing the waters for 2 (TWO) Roth IRA’s and an HSA.. would love to hear your opinion.
Married Filing Jointly / Wife is a stay @ CEO MoM
Fully Funded 401k
Current Spousal IRA Traditional (already contributed 2014) – 40ish -k
Current Personal IRA Traditional (no contributions, it’s left over from the past) – 75ish -k
Current Roth IRA (just started it this year, contrib’d 2013 & 14) – 11ish -k
HSA – not started yet, Sept 2014
Want to start a ROTH for my wife and no longer contribute to the traditional.
this gives me about
1935/mo or 23220/yr going into a tax deferred 401k
916.66/mo or 11000/yr going into an after tax / tax free withdraw
xxx.xx/mo or max/yr going into HSA
My assumption is; I’m 45 now, I live in Washington, my 401k/Traditional IRA account(s) should be enough taxable money, my thought was to have some tax free money for any surprise expenses, whether it be medical (Roth + HSA) or something crazy, like a late life crisis and I need a motor cycle or dune buggy, or land rover and run through the desert…
Anyway – the short is, I was considering two ROTH’s instead of one… thoughts?
Steve
Hi Sam,
I found your website while researching the differences in IRS. I recently retired and need to do something with my 401k account. I will be 62 this summer. I know my income will be less in my remaining years. I plan to only work part time if at all. So from what I gather from your article I would be smarter to roll the money into a regular IRA and keep my fingers crossed that the tax rate doesn’t increase significantly before I die. I live in Texas.
I am looking forward to receiving your newsletter.
Thank you
Hi Sam,
I really enjoyed this post…I have been reading your blog for sometime and finally have the courage to comment.:-)
So, my company has this mysterious profit-sharing plan and we really have no idea if/when it will fund. When it does happen, and we get a report, it’s like Christmas.
For someone like me, with no 401k, would a Roth be your recommendation? I fall in the middle class tax bracket.
Thank you!
Catina
Hi Catina,
It depends on your beliefs about future income growth. I would say traditional IRA first.
“2) You’re in the 25% marginal income tax bracket or lower. If you earn under $89,350, you are at most in the 25% marginal federal income tax bracket. The 25% tax bracket ranges from an income of $36,900 to $89,350. (The 28% tax bracket is from $89,350 – $186,350 and the 33% tax bracket is from $186,350 – $405,100). It’s not good enough to just be in the 25% tax bracket or less, because you are in the absolute sweet spot of middle class America where you will likely never be a target for income tax increases. You must also be absolutely BULLISH about your income prospects. If you are a young person who is a superstar at your firm with income visibility over $89,350 then feel free to contribute up to $5,500 to a ROTH IRA now because you will be completely creamed by the IRS in the future. If you are a late bloomer who is finally on track to maximizing your potential, then contribute to a ROTH IRA. Just don’t forget to continue maxing out your 401(k) during this time.
3) You’re going to make over $129,000 or your spouse is getting a big raise. After you make over $129,000 as an individual or $191,000 as a married couple, you can’t contribute to a ROTH IRA. It is still unknown how the government comes up with such arbitrary amounts, independent of location. Don’t they know that San Francisco is much more expensive than Des Moines? Contributing to a ROTH IRA is particularly useful for those who are on the hunt for sugar mammas or sugar dads. If your prey actually proposes, then contribute as much as you can during the engagement before it’s too late.
Thank you Sam!
Sam,
There are some estate planning benefits to a Roth IRA.
Also, there are no mandatory distributions at age 70 and 1/2, and Roth distributions do not affect tax ability of Social Security benefits.
You have already covered the flexibility of withdrawing your contributions without penalty. This could be an important option for folks that get into a sudden liquidity crisis.
If you are a disciplined person, I think having greater control of your money and the flexibility to choose almost any investment is much better than a typical company 401k plan. But then again, I’m a finance/investment guy, so what works for me, might not work for the typical American. For most people, the automation of 401k plans is the best.
In regards to the option of moving to a low tax (or no tax) state: That’s not likely. The vast majority of folks will get settled in their current state, in regards to friendships, family, etc. The older you are, the less comfortable you will be with moving out of your home town/state, to a strange place, just to save a few bucks in taxes. I haven’t seen or heard of too many millionaires moving from California to Wyoming! Not that there is anything wrong with Wyoming. It’s just too huge of a culture shock for someone whom has spent their entire life on the west or east coast.
Ahh, clearly you haven’t been to Jackson Hole recently! Tons of NYC, CT and CA transplants!
Well…. You certainly can’t be whining about severe cold winter weather if Jackson Hole is your intended home.
It’s a ski resort area with a population of about 21,000. Not much different than Aspen or Park City.
Yes…. You run into a few wealthy people on the slopes, whom are visiting for a few days. But, not exactly a mass movement to relocate!
Now Florida…. That’s different. And Texas has possibilities. But again….. People have considerable inertia. If you spent the last 40 years of your life in SOCAL, it is going to be very difficult for you to pick up and move. I don’t think lower taxes are as high of a priority for most folks.
So along that line of thought: Since a resident of a high tax state (such as California) is likely to remain in his/her state during retirement, there is an implied tax advantage to the Roth IRA. 30 to 40 years of successful (hopefully) investment returns being withdrawn tax free. Whereas, all 401K distributions will be taxed by both the IRS and likely the state.
As ACE points out there is no required distribution with a Roth as there is with a traditional.
So another reason to have a Roth – you plan on never needing the money and want to pass it on to your heirs completely tax free, this is why I have a Roth. I know, I know, why save it if you don’t need it, no one would do that etc… Sometimes it makes sense, you have a great pension, you have a special needs child, you have several children, you just hope to stick it to the government….
Of course, I recommend converting from a traditional to a Roth once you stop working so you can enjoy the tax break the traditional provides you.
Here is a scenario in which Roth makes sense: You make very little money now, so you’re at the lowest tax rate, but you stand to inherit a fortune, which will be taxed at the highest rate.
Sure. But if you stand to inherit a fortune, not sure how meaningful a ROTH or IRA for $5,500 a year really matters.
If you generalize from inheritance to any gift, I do think this also makes sense. Somebody else paid the taxes on it, why would I want to do so again?
This is kind of a weak reason, but people may end up saving more in a Roth than a Traditional IRA, simply because one uses post-tax money. To really take advantage of the Traditional IRA, people have to also invest the extra in-year income gained from the tax deferral. I’m not entirely sure a lot of Americans will take this extra step, as we’re not particularly good savers. For people who aren’t natural savers and are likely to just invest the same $5,500 pre-tax or post-tax, you might be better off with the Roth.
I’ve been pondering a switch to a traditional IRA for a while, but keep on contributing to my Roth out of habit. Does a bad habit count as a reason?
Would this approach change at all if you wanted to retire before 59.5? I am planning on reaching finical independence by 40 but want to access my funds to support that independence. So as a result, I am investing in an IRA and separate index funds to support my early retirement. Should I focus more on my 401K?
Good question. It all depends on your overall income power, assets, and liquidity.
My hope is that you have a high enough income to max out your 401(k), and then rollover your 401(k) into an IRA.
See: The Benefits Of Rolling Over Your 401k Into An IRA
Then you can enact rule 72(t) to withdraw funds penalty free, and hopefully have alternative income or after tax investments other than a ROTH to provide for your early retirement lifestyle See: Rule 72(t) For Early Retirement Withdrawal Penalty Free
If you have a high enough income to maximize your 401(k) and then contribute to a ROTH and then contribute to an after
Sam, did you withdraw your entire 401k over 5 years, if so how? After all, it appears that the calculation is based on life expectancy, and you’re in your 40’s with 40+ years to go, unless I missed something.
Did I miss the part where you say it’s OK to contribute to a Roth IRA if your combined (married filing jointly) income exceeds $191k AND you’re going to do so through an Traditional IRA conversion into a Roth?
I realize that this only makes sense when one can’t get the tax deduction from the Traditional IRA contributions AND that each Trad. IRA dollar converted is considered by the IRS as being part contribution that received a tax deduction and part contribution that did not receive tax deduction, equal to how your total Traditional IRA balance is split.
For many of us though, this is the only way to get some tax deferral benefit off of our next retirement savings dollar.
Just saw your #10 update!
I opened a Roth IRA very early on in my career when I didn’t have access to a 401k. I was thrilled when I switched companies and got access to a 401k with company match.
Maybe I’m misreading the IRS website but I’m choosing to contribute to a Roth beacuse with a traditional IRA I will get no tax deduction beacause my modified AGI will be over 70,000.
At least with the Roth I will still be getting some tax benefits in the future. But if I contribute to a traditional IRA I get no tax benefit now and no tax benefit later, so what’s the point!
It’s surprising that everyone talks about the basics of the Traditional IRA versus Roth IRA, but most people fail to mention that after a certain income the Traditional IRA gives no tax benefits!
Maybe I’m reading it wrong but here’s the IRS website with that detail.
Since my husband and I are both retired, we can no longer contribute to IRAs of any kind. We have both traditional and Roth. My concern about a Roth is that even though the distributions are currently tax free, I can easily envision the government deciding someday that 1) they need to tax the distributions simply because it needs the money or 2) it isn’t fair that people who saved in this vehicle has tax free income while others who did not save do not have tax free income. In the name of fairness or leveling the playing field, it will take part of our IRA to give to those who didn’t save. (You can probably detect my politics based on this comment.) I actually like the hiding the money in the mattress scenario you described. Gold, anyone?
Anything is possible, however I think this is highly unlikely.
Sam, I want to give you my information to see if I am making the right move. Currently I make 50k before taxes, and these are my following deduction:
HSA – 2800 (+500 from company for 3300 max)
401k – 5000 (10% + 7% match, this is max they will match)
Standard Deduction – 6100
Other – 3000 (pre tax deductions such as health, vision, dental ect.)
So my taxable wages are roughly 33k putting me in the 15% bracket. I am 24 so I assume I will be making a lot more money throughout my career and expect to be in higher (or at least not less) than 15% bracket throughout retirement. I have maxed out my roth IRA for 2012 – 2014, but I want you input in my scenario I think I made the right choice. Do you agree? If not could you please explain where I am making the mistake as I don’t know every little detail regarding taxes and such.
My argument for having a Roth would be if you’re already taking a small amount of your portfolio and trading stocks with it trying to hit a home run then why not do it in a Roth vs a normal brokerage account.
My 401k is already maxed out but even if it weren’t I can’t trade stocks in it. Best I can do is a mutual fund that tries to match the S&P. Why if somebody in my scenario also wanted to put a little money on stocks wouldn’t you open a Roth to do so? If I were to hit a home run I have the option of selling and not having a huge tax bill.
That is a great point Shaun. If you are a tweener (point #10), then you might as well contribute to a ROTH if you don’t need the money until 59.5 for the flexibility. I guess it all depends on how much time you want to spend stock picking and how good you are at stock picking. I do think it’s worth chasing unicorns when you are young and have time.
I certainly agree with maxing out the 401K first – there are just too many benefits to overlook. Most people who are able to do so have incomes above the threshold for making a deductible IRA contribution. If their incomes are between the deductible IRA max and Roth max and they can afford it, making a Roth contribution makes sense. For those over the Roth max, you can do a “backdoor” Roth contribution – by making a non-deductible contribution to a traditional IRA and then converting it to a Roth (a rather strange loophole currently available). It’s nice to have some tax-free funds available in retirement.
Excellent point Chris. Have added reason #10) Income Tweener.
I make about $48k a year and pay about 15% in taxes. I’m still young and I know I’ll make more money in the future, but probably not more than $89,350/yr when I retire in 35 years. I’m maxing out a Roth IRA every year, but I don’t have a 401(k) at work.
When determining between a Traditional or a Roth IRA, I figured the Roth made more sense because I will be earning more (and therefore paying more in taxes) in the future. Is my analysis off?
Sounds like you made an assumption, not an analysis ;-). Lower tax rates make it less of a difference for sure, but you should really run the numbers (making sure to account for the difference between marginal tax rate savings on Traditional IRAs and average rate payout on withdraws vs paying full Marginal rate on Roth contributions now).
Howdy mate, good self-reflection and scenario for folks who don’t have a 401(k) at work. If you aren’t going to make more than $89,350/yr and are making under $60,000 a year, then I would contribute a traditional IRA first b/c your 25% tax rate is the same. The end result is a wash on taxes, and you keep the OPTIONALITY of moving to a lower taxed state in retirement if you so choose. If you contribute to a ROTH now, you give up all optionality.
But if you are in the following tax rates, and believe you will make over $36,900 but under $89,350 a year to reach the 25% tax bracket, then I’d contribute to a ROTH IRA. Just make sure you can afford it.
10% on taxable income from $0 to $9,075, plus
15% on taxable income over $9,075 to $36,900, plus
Sam,
FYI: Some states do not offer an income tax deduction for 401k contributions (example PA). That changes the math quite a bit.
California has crazy high income tax rates, so thank god they still allow this deduction (for now)!
Fascinating! You sure about that? Could you provide some resources. Just doing a quick search and I’ve found the below passage on Kiplinger’s.
“The Keystone State shows its Quaker roots and extends a friendly hand to retirees. It is one of the most generous states in the nation when it comes to offering income tax exclusions on a wide variety of retirement income. Pennsylvania does not tax Social Security benefits or any eligible Pennsylvania public or private pension plan. Neither does it nick distributions from 401(k)s, IRAs, deferred-compensation plans or other retirement accounts. Property taxes can be steep in some communities, though. https://www.kiplinger.com/tool/retirement/T055-S001-state-by-state-guide-to-taxes-on-retirees/index.php?state_id=39#7rAZ9cVB8bZsAjmX.99“
Just did a PA tax return for a family member with a 401k. They had to pay 5% on total earnings (including 401k contributions). So in effect, it becomes a defecto Roth as far as PA is concerned (assuming they don’t tax the withdrawals).
FYI: PA residents file local tax returns with their townships in addition to the state income tax.
Here’s a link to the PA Department of Revenue:
Sam — I am assuming this info also applies to a Roth 401K?
Yes, I think all the same logic applies, but we should do more research just to make sure since I was focused solely on a ROTH IRA.
I’d like to see something on the Roth 401k as well. Unfortunately I might be messing up twice as bad since I max out a Roth 401k and contribute $5500 to a Roth IRA through the backdoor method. Like you said, I can always reverse course!
May I ask you to talk out the rational why you are doing what you are doing? A lot of times, just talking things out helps a lot!
My rationale for contributing to a Roth 401k has been for tax diversification purposes. My company matches 1-to-1 up to 9% in my 401k plan. However, the money that the company contributes is obviously pre-tax dollars. I also have a defined-contribution pension plan with my company that will have taxable withdrawals. I currently live in Texas (no state income tax). I should make around $130k this year, but my income should see marked increases over the next 10-15 years. Do you still think that pre-tax contributions is the way to go for me? If so, I could definitely use the extra money to save up faster for a down-payment on my first rental house!
Just thought of something. If you work in Texas, and plan to retire in Texas, then the moving for lower state tax argument is mute. Therefore, the argument is to lean more towards maxing out a traditional 401(k).
But given you plan to buy a rental house, then it’s a little trickier. However, with a $130K income, you should be able to max out your 401(k) and save money for a rental house. I hear TX has some great property for under $300,000!
I wonder what the present value of no-govt-hands-in-your-pocket-forever by contributing to a Roth? :)
I am definitely against a Roth if contributing pre-tax and post tax are mutually exclusive. I love the idea of putting in the max to a 401K and then putting the first $5,500 of investments into a Roth. I opened up a Roth brokerage account recently and am looking forward to the tax-free trading for life! :)
I’m confused as well. I thought you couldn’t contribute to a Traditional IRA if you max out your 401K. Thus, only option after maxing out 401K is ROTH IRA.
You can contribute up to $5,500 to an IRA in 2014, which jumps to $6,500 if you are age 50 or older. However, if you have a workplace retirement plan, the tax deduction for traditional IRA contributions is phased out for individuals with modified adjusted gross incomes between $60,000 and $70,000 in 2014 ($96,000 and $116,000 for couples).
The tricky thing is whether you will have ENOUGH money to live comfortably if you max out your 401(k) and then try and max out your IRA making under $60,000 a year. It’s definitely possible, but it may not be easy.
We wrote a post on contributing to a 401(k) and to an IRA on Daily Capital:
I’m curious about what you think about converting 401K to Roth between the ages of 59 1/2 and 70 1/2. Since I’m planning on scaling back to part time work at around 60, I think my official income will be low enough that I have space at either the 15% or 25% bracket. My plan is to withdraw from the 401K up to whatever the top of that bracket is, and move the funds to a roth, to let it continue to grow tax free. This should help me reduce my RMD’s. Thoughts??
Cathy, given you are at your age and have very clear visibility what your income will be, then I say go for it!
New to the site. Good stuff, quick question:
Max out a traditional IRA and then a ROTH IRA? I’m confused how that would actually work, do they not share the same $5,500 contribution limit?
You are right to be confused, as I didn’t make point #1 clear enough. Based on your feedback, I’ve altered the language:
1) You’ve maxed out your 401(k) already. If you’ve contributed $17,500 to your 401(k) and $5,500 to your traditional IRA (only possible for individuals making under $60,000 or married couples making under $95,000), then go ahead and contribute to a ROTH IRA for tax diversification purposes. This is a trick statement because once you’ve maxed out your traditional IRA of $5,500, you can no longer contribute to a ROTH IRA. What you can do is split the $5,500 between a traditional and a ROTH to diversify your tax liability. Even if I tell you that tax rates aren’t going up for the middle class because greedy politicians need the middle class to keep them in power, I don’t know for 100% certainty that people making less than $200,000 a year won’t see higher taxes in the future. – See more at: https://www.financialsamurai.com/the-only-reasons-to-ever-contribute-to-a-roth-ira/#sthash.m8mMmLTF.dpuf
Sam,
I am confused by point 1. I don’t think you can contribute over 5500 combined to a Roth and traditional.
I have always thought that a Roth was beneficial for someone without access to a 401K but who still wants to maximize their tax advantaged savings. When you contribute a post tax 5500 to a Roth it is a larger amount than a pre tax 5500 to a traditional.
Adam, I’ve clarified point 1. Thanks for bringing this up.
Care to share the math on a ROTH IRA contribution being a larger amount than a pre-tax $5,500 contribution to a traditional given the max ROTH IRA contribution is $5,500?
I assumed the tax rate would be equal for the Roth or Traditional. If you use the 25% rate as an example, to put away $5500 it requires $7333.33 pre tax but you end up with $5500 when you withdraw. For the traditional it only requires a pre tax $5500 but after tax, you only withdraw $4125.
Again, this only argues for the Roth if you are maxing out all other retirement possibilities and want to put away as much as possible in a retirement account.
Great discussion. This is the type of math gymnastics I like to do.
So for the ROTH, it requires $7,333.33 at a 25% tax rate to contribute $5,500. That is BAD b/c it takes $1,833.33 more to have an equal $5,500 invested in a traditional IRA. The traditional IRA holder can use the extra $1,833.33 before taxes on something else that provides different types of utility, or can invest the proceeds for an additional boost to the $5,500. From this point of view, I say the benefit of being more liquid and having more options (one of the key underlying premises of this post) makes contributing to a traditional IRA that much more attractive.
The good thing about the ROTH is that the $5,500 principal is left over to withdraw vs. only $4,125 left over to withdraw for a traditional IRA, all else being equal. But all the while during this growth process, the math balances itself out b/c whether you pay 25% taxes up front, or 25% taxes at the end, the amount is the same.
I still think if your only goal is to turn $7333.33 into the maximum amount at 59 and 1/2 your best option is to put it all in a Roth. In the case of the traditional, you take the pre tax 1833.33 that you saved, pay the 25%, then invest it until retirement when you pay additional capital gains taxes which were avoided by the Roth.
I enjoy the math gymnastics as well. Thanks for the responses.
Maybe I’m missing something but I think you left out a key scenario. For folks who have access to a 401k account and make over 69k single, you don’t get to contribute pre-tax money to a traditional Ira. So the option becomes no benefit vs tax free growth with a Roth. In that scenario the Roth is the better option as you get some for of a tax break. Unless I’m misreading the current tax laws and please correct me if that is the case.
Also, my understanding is that the 5500 annual limit is applied across all Ira accounts and isn’t on a per account basis. So split evenly between two accounts, the most you could contribute would be 2750 per account.
You are correct. Point #10 has been added in the post. So many little nuances, which is why I love this community!
I think you touched on this in your other article but you should clarify that Average vs Marginal rates is actually what kills the ROTH. When you contribute you pay at the very top of your tax bracket (your marginal rate), but when you withdraw from a regular IRA you pay at your average rate (assuming like most people you are relying on this as your primary income in retirement). So even if you are withdrawing 100k from your IRAs to live on, you aren’t paying at 25%. You get to subtract off all the deductions, etc, then pay at 10%, then 15%, and then 25%. So while i am in the 25% tax bracket my average federal tax rate is <8%.
Unless you have a huge side income stream, there is an almost 0% chance of paying more taxes from the traditional IRA.
I will say that i think it might make sense to plan for up to 5 years of expenses in ROTHs if you are planning on doing a Roth conversion ladder for funding early retirement. However you should definitely be maxing your 401k first if this is your plan.
Great point Lucas. And yes, that is exactly right. When contributing to a ROTH, you are contributing based on your HIGHEST MARGINAL TAX RATE. When withdrawing, you are withdrawing from the progressive lowest to highest marginal tax rate, so the tax is lower, like for like.
Thanks for bringing up this brilliant point from the old post. I will incorporate this point in this post.
It has been mentioned in other comments, but the problem I have with this argument is that it is either / or. This seems to be narrowminded to me. I have a 401(k) and a Roth. One of my biggest tax concerns for retirement is the required minimum distribution for the 401(k). (that is, I see it as a task to manage) The Roth is a tool to help me do this: if I want to splurge, or I have a large emergency to pay for, or if I find my spending creeping up into the 25% rate or above, then I will switch from the 401(k) to the Roth for withdrawals. This balance of spending 401(k) up until the 25% bracket is a way to manage the base tax, and I will use other things to manage deductions, etc. to end up with the lowest overall bill.
A switch from income tax to VAT is a valid threat, but I would have to believe this will not occur in isolation: there will have to be some consideration for Roths if this happens–either a tax credit for Roth withdrawals, or some other equalization. Count on the lobbyists to push for that!
to clarify, having both 401k and Roth is a good thing as well. But you have to prioritize where you save, and how much you do in each.
My personal recommendations to people are usually to save up this list as far as you can go:
1) 401k up to company match – free money & decrease on MAGI
2) HSA max (reduces MAGI, tax free in, tax free out, social security and medicare tax free, and you can save all medical expenses and get those out at any point in the future – even 50 years, and after 59 1/2 turns into regular IRA for withdraws. So basically best of both ROTH and IRA with some slight decrease in flexibility on spending – but who isn’t expecting major medical expenses in the future)
3) 401k Max – reduce MAGI as much as possible and maximum tax savings
4) Roth Max – Tax diversification after reducing taxes as much as possible. You can make an argument for regular IRA at this point, but if you can max your 401k & HSA you aren’t going to be too far off with going with a ROTH here.
5) Taxable accounts / Debt reduction.
If you have money that can go into item 5 then by all means go for the ROTH. But i have run the numbers many times with many scenarios and Traditional 401k always beats ROTH. You can always more money into ROTH for more flexibility through conversions in years with less spending (which is my plan). But if you can max all of these tax advantaged savings vehicles you are doing great!
Could you point me to where this was illustrated in a previous post, as Lucas says? Not grasping what you mean here.
Active Duty Military
1. Max 401k every year ( No employee Matching)
2. Put 5500 into a Roth for the wife and I
3. Pay down Investment Property about 100-200 monthly
Roth IRA just makes sense for us, I now by putting roughly 28500.00 away every year will set me up for success.
I am hoping and praying I get stationed in Texas, Florida or an income state tax state here shortly.
And hopefully a pension yes? If so, then financial success is written all over your cards.
Nick, have you looked at the Roth TSP? Might make sense if you have any tax free income (BAH, BAS, Combat Zone Tax Exclusion). Military folks are usually in the lowest tax brackets of their working lives while they serve.
The Roth TSP has one very serious flaw — you CANNOT withdraw from one or the other of your regulary TSP and Roth TSP. Rather, any withdrawals automatically come from BOTH accounts in an amount proportional to the balance of each account. For example, if you have 50% of your money in the traditional TSP, and 50% in the Roth, and you withdraw $1,000/month, $500 will come from your regular TSP, $500 will come from your ROTH TSP. Far better to max out your tax-deferred, regular TSP, then dump $5,500 into a Roth IRA with Vanguard (if you’re inclined to have a Roth account — which can be helpful if you find yourself bumping up into a higher tax bracket, if you can pull an amount out of your Roth that drops you into the lower bracket).
Hi Sam, is there any reason you are not talking about the backdoor Roth IRA method? You mentioned in reason #1 that is would ok to contribute to a Roth IRA if you had already maxed out a 401k and traditional IRA, however you cannot max out both types of IRAs. Per IRS rules, you can contribute to both a Roth IRA and traditional (as long as you are within the income limits), however, the total cannot be higher than the IRA limit (typically $5500 in 2014).
Could you possibly revise reason #1 to state that it is ok to contribute to a Roth IRA if you have already maxed out your 401k but do not qualify for the traditional IRA deduction due to income limits? Also, be aware that in the case you maxed your 401k but have a MAGI higher than 129k single 191k married, you can still contribute to a Roth IRA through the backdoor Roth method. The backdoor Roth method involves contributing to a nondeductible traditional IRA and then converting it to a Roth IRA.
These are good points, and I have revised the post to provide more clarity in point #1.
The backdoor ROTH IRA still goes against what I believe since its still paying taxes up front. But if any one of the conditions above apply, then it’s not so bad.
I don’t understand your comment on the backdoor Roth IRA method with respect to paying taxes upfront. If your income is above the threshold to contribute to a normal tax deductible and above the Roth income limit then you can do the backdoor method. But this is after-tax money already so there is no extra taxes to pay. Frankly it’s a no-brainer.
I do the backdoor method even if our joint income is below the Roth limit because I can contribute early (say Jan 1 of 2014 for the 2014 contribution, instead of waiting until I file taxes April 2015 and not have to worry if our AGI is below or above the limit).
Forgot to add that we also max out our traditional 401k’s so we are out of pre-tax options.
Bump to Jason Perez’s comment. I think you misunderstand the backdoor Roth because it is converting a nondeductible contrib. to traditional IRA into a Roth.
Do you still think Roth is wrong under these circumstances:
-you have maxed your 401(k), including doing an after-tax 401(k) followed by an after-tax-to-Roth in-plan conversion
-you have used any other deferred compensation plans available to you
-you have enough securities in a taxable brokerage to reliably generate enough tax loss harvesting opportunities to get the annual $3,000 deduction against income.
-you are above the deductibility limit of traditional IRA, so you do the backdoor Roth (nondeductible contrib. to traditional IRA, convert to Roth IRA)
The alternative is to just to throw this cash in a taxable account–but I assume that you’d at least think that a tax-advantaged account like this makes sense?
I’m interested in SAM’s response to these posts. I just started doing the backdoor ROTH this year after extensive research. I f already maxing out on 401k, I was unable to identify any drawbacks of the backdoor method.
The only drawback is that the it’s locked in for 5 years without withdrawal penalties. And this drawback applies to each conversion separately.
Not the contribution portion
Since my post in March 2018, and maximum yearly allowable contributions to Roth IRA to date of approximately $33K on stocks, the total has grown to about $40K. I understand that there is a 5-year period without withdrawal penalties, but does this mean that say my last year’s contribution of $7000 can only be w/drawn without penalty 5 years hence for that particular $7000 investment, i.e. 2024?
Hi Sam,
My wife and I contribute to our Roth’s for the following three reasons:
1. We will be below the 25% bracket cutoff this year
2. We do live in a city and state without local or state taxes
3. War or no war, politicians will have to raise taxes eventually….because they are too weak to keep costs in check. I think the Roth’s tax benefits may go away, but I think that would be after many many other tax increases.
For us, I consider a Roth IRA tax diversification.
-Bryan
See my below post for explanation on why Average vs Marginal rates is actually what kills the ROTH. The biggest risk to the ROTH tax benefits would be the shift from income tax towards VAT or more sales tax. Tax diversification is good, but i totally agree with SAM that you should max your 401k first as this reduces income and MAGI which increases eligibility for tax credits, etc. . Traditional IRA and ROTH do not affect MAGI!
Hi don’t know Bryan, your statement:
“3. War or no war, politicians will have to raise taxes eventually….because they are too weak to keep costs in check. I think the Roth’s tax benefits may go away, but I think that would be after many many other tax increases.”
Is EXACTLY the type of government mind bender they want citizens to think. It’s a heads they win, tails you lose type of mentality from their point of view!
But it’s all good. Like I said, contributing to a ROTH isn’t the end of the world. At most it’s around a $350 extra cost per year of contribution all else being equal.
Sam