Saving for retirement is crucial to long-term financial success and comfort. But according to an expert, you may be doing it all wrong.
The two most popular investment vehicles for retirement are 401(k) and IRA accounts, each of which has traditional and Roth versions. Traditional accounts are funded with pre-tax dollars, which are taxed at the time of withdrawal, while Roths are funded with after-tax contributions, so the money grows tax-free and withdrawals are not taxed. Additionally, Roth accounts are exempt from required minimum distributions.
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Investors who expect to be in a lower tax bracket when they retire (such as higher earners) typically prefer traditional accounts, while people who are early in their careers and not yet earning their maximum income may opt for a Roth account.
Ed Slott disagrees, saying that Roth accounts are for anyone, anytime. The accountant at his eponymous firm, which specializes in IRA investing and analysis, is the author of “The Retirement Savings Time Bomb Ticks Louder: How to Avoid Unnecessary Tax Landmines, Defuse the Latest Threats to Your Retirement Savings, and Ignite Your Financial Freedom.” Slott says savers are likely to pay more if they wait to pay taxes on their distributions.
The current tax rates set out in the Tax Cuts and Jobs Act are expected to be phased out by the end of 2025. It is not yet clear what the new rates or brackets will be.
Slott says he’s seen the consequences of waiting before. While working on a tax return for a client who preferred a traditional retirement account during his higher-income years, he discovered that his client’s income was higher in retirement than it was during his prime earning years because his IRA was growing so much and his required minimum distributions were higher than the income he had when he was working. His client was shocked, but he wasn’t.
Slott spoke with MarketWatch about how to determine if a Roth account is right for you, what to do if you don’t have a Roth 401(k) option at work, and how to weigh the pros and cons of taking a tax hit right now.
MarketWatch: Why did you write this book?
Ed Slott: The biggest thing is the ticking tax time bomb. The taxes that people don’t realize are building up in IRAs and 401(k)s. That money hasn’t been taxed yet. You get deductions as you contribute and that’s the deal. You get the deductions up front and like any deal with the devil, there’s a day of reckoning — that’s when you have to take that money out. What I’m afraid of is higher taxes in the future. Given the national debt situation, if Congress ever decides to do something about that debt, they may never do it, but let’s say they do get serious about it, there comes a critical point. The people who are most at risk of having taxes raised are the people with IRA money. It’s like a big juicy steak for Congress.
MW: Do you think people think about this when they contribute?
Conclusion: Most people are short-sighted. Even if the market is doing well — well, the last few days, who knows — but the market is doing well in the long run, they look at the balance in the account. A lot of that money is owed to the government. They think it’s their money, and that’s dangerous. You have $1 million in an IRA or 401(k), you might think you’re going to retire on that money. You can’t get to that money unless you pay taxes first, and you don’t know what that is.
MW: So what is the argument for using traditional accounts instead of, say, a Roth account?
Conclusion: I stand alone in this, but I say there is no reason to contribute to a [traditional] 401(k) or IRA because you’re just building a future tax account. Take the money out. Move to a Roth and build a tax-free account. A Roth is insurance against what taxes can do to your standard of living in retirement. You have a debt on your retirement account — your IRA is an IOU to the IRS. It’s kind of like a mortgage on a retirement account, but with a mortgage, everybody understands that. You know how much you owe, you look at the statement. With a retirement account, you don’t know how much. Imagine applying for a mortgage and you’ve done your homework and you ask the bank questions like, “What’s the interest rate?” And the banker says, “Don’t worry about it.” Instead, the banker says, “We’ll tell you how much you owe based on how much we need it and when.” Who would sign up for that?
MW: What about people who are closer to retirement and may not be able to switch as easily?
Conclusion: Use the current tax brackets. These are historically low rates. I have a rule that always applies, because it is always true: always pay taxes at the lowest rates. It is very simple. Nobody likes to pay taxes up front, so they let it go.
MW: Traditional accounts are usually more ideal for people in their higher income years. How do you find that balance when you earn more than you will later earn?
Conclusion: That’s the number one question when we do training programs. The whole thing is to move your money from accounts with perpetual tax to never tax. It’s all one big bet on where you think the tax rates are going to be. I believe they’re going to be higher, but if Congress doesn’t do anything about this problem and the tax rates stay the same, if you do nothing, your account balance is going to be higher because of all your contributions and earnings and you’re going to be in a higher tax bracket. Then you’re going to be forced to make withdrawals and the taxes are out of your control.
The key is to monitor the taxes that you pay. You say I’m in a higher tax bracket now, that’s a myth that you’re going to be in a lower tax bracket when you retire. The reason I say that’s a myth for most people is because those with the largest balances and incomes think that they’re going to be in a lower bracket because they’re not going to have W-2 income. That may be true, but if you don’t do anything, that IRA is going to grow and grow and grow and grow and then you’re going to be forced to take that money out (at age 73 if you have RMDs).
Once you retire, your deductions are lower, you have fewer credits in general. You don’t have the benefits of dependent children, you’ve probably paid off your mortgage, you don’t have a deduction for your IRA or 401(k), and you probably take the standard deduction like most people do.
The only way it won’t pay to convert to a Roth is if Congress somehow cuts taxes. If that doesn’t happen and tax rates don’t go up, what’s the worst case scenario? You’ve converted and you’ve locked in a 0% rate going forward. People don’t want to pay taxes up front, but the tax on retirement savings is not if, it’s when.
MW: You mentioned using Roth accounts instead of traditional accounts. But what about in cases where employees don’t have a Roth 401(k) option at work?
Conclusion: Well, they can do their own Roth [IRA]but then they are subject to income limits. They can do a regular 401(k) at work, that is their only option if they want to put away a lot of money. There are income limits for Roth accounts and contributions, not for conversions.
MW: Roth earnings limits are one hurdle that comes to mind. What can or should people do during times when they can’t contribute directly to a Roth account?
Conclusion: If there are no income limits on conversions — we’re just talking about contributions — they can convert to Roth. There’s no limit on how much they can convert or how much they earn. If they want to contribute to a Roth, even though their income is too high, they can do a backdoor Roth, where you contribute to a nondeductible IRA and then convert it. You’ll end up in the same place.
MW: Is there anything else you think retirees should know?
Conclusion: At least think about it, because you have low rates now. Rates are on sale. Nobody likes to pay taxes up front, but the last thing you want to do in retirement is worry about taxes.
(This interview has been edited for clarity and length.)
