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A Roth IRA offers significant benefits for retirees. As an after-tax account, distributions from Roth IRAs are generally tax-free. This can save you a lot of money in retirement, but at the expense of tax payments while you save. You spend more today to build your portfolio, but save money later.
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For example, suppose you are married and in your late fifties. You and your spouse have a 401(k) with $1.6 million and are building a strong retirement. Would You Benefit from Switching to Roth Contributions?
In this case, most households could benefit from sticking with their pre-tax contributions, but the answer will depend on a number of factors. Here’s how to think about it.
As an after-tax account, a Roth IRA offers no upfront tax deduction or credit for your contributions. The benefit comes in retirement when you can withdraw your money tax-free.
This is the reverse of a tax-deferred retirement account, such as a traditional IRA or 401(k). Such accounts provide an income tax deduction on all contributions – up to annual contribution limits – for the year in which they are made. You then pay income tax on all withdrawals (both returns and principal) at retirement.
Upfront taxes are the biggest disadvantage of a Roth IRA. The money you spend on taxes is capital that you could otherwise have invested in long-term tax-deferred growth. For example, suppose you pay an effective tax rate of 20%. With a Roth IRA, you would need to earn $1.20 for every $1 you save to account for taxes on your contribution. A 401(k), on the other hand, allows you to save and invest the entire $1.20 of pre-tax income.
But there are significant advantages to Roth IRAs. First, and most notably, you can keep any money you withdraw from this account (provided you follow a few rules). In contrast, all withdrawals from a 401(k) are effectively reduced by your income tax rate.
Second, a Roth IRA is great for maximizing growth. The longer this portfolio grows, the more value the tax-free withdrawals will have. Third, Roth withdrawals can help you keep taxes on your Social Security benefits low because they don’t increase your taxable income.
Fourth and finally, Roth IRAs are not subject to required minimum distributions (RMDs), so you can keep the money invested for as long as you want.
If you’re unsure whether a Roth IRA is a good option for your financial circumstances, consider talking to a financial advisor.
A couple does some math on a calculator to determine whether they should switch to Roth contributions or complete a Roth conversion.
There are two ways to build a Roth IRA if you already have a retirement account: contributions and conversions.
With a Roth conversion, you move the money from your existing pre-tax portfolio to a Roth IRA. There are no limits to how much money you can convert. For example, someone could roll over their entire $1.6 million 401(k) in one year.
With contributions, you begin putting newly earned income into a Roth IRA each year. These savings are subject to standard IRA contribution limits. In 2024, you can save up to $7,000 in IRAs or $8,000 if you are age 50 or older. Because IRA contribution limits differ from 401(k) limits, you can contribute to the limits of both a Roth IRA and a 401(k) in the same year if you have the capital.
In either case, the money flowing into a Roth account counts toward your taxable income for the year. With contributions, this means you can’t deduct the money you save in your Roth IRA. When you convert, you include the transferred amount in your taxable income for the year. For example, if you converted the entire $1.6 million, you would pay taxes on the lump sum.
If you are converting a portfolio before taxes, make sure you have enough cash on hand to pay the resulting taxes. This is especially true for investors over the age of 59 ½, as above this age you can use the money from your portfolio to pay income taxes.
Finally, Roth contributions are subject to the five-year rule. Any income generated by your contributions must remain in the account for five years, regardless of your age or retirement status. For example, suppose you contribute $8,000 in 2024 and $8,000 in 2025. Any interest earned on the first $8,000 must remain invested until 2029. The income from the second €8,000 must remain there until 2030. Violating this rule can result in income taxes and a 10% interest fee. fine.
Roth conversions are subject to a separate five-year rule that requires the converted amount to remain in the account for five years before it can be withdrawn without penalty. However, each individual Roth conversion has a five-year waiting period.
Fortunately, the five-year vesting periods start retroactively, so if you do a Roth conversion or make a Roth contribution in December 2024, that means your five-year period starts in January 2024.
If you want to add a Roth account to your mix of assets but don’t know whether contributions or conversions make the most sense, consider matching with a financial advisor and talking it through.
It’s entirely possible to spread your retirement savings among an IRA, 401(k), and Roth IRA.
So should you switch to Roth contributions? For example, let’s say you’re 57 and have $1.6 million in your 401(k). Is now a good time to prioritize Roth contributions over current 401(k) investments?
While it depends on your individual situation, chances are the answer is no.
The rule of thumb is that a Roth IRA works best for people who expect to be in a higher tax bracket in retirement. As a result, Roth IRA contributions tend to have the most value earlier in life, when most households earn less money and have more time to grow their money tax-free.
In contrast, a 401(k) account and other pre-tax accounts tend to work best if you currently pay a higher tax rate than you will in retirement. This allows you to maximize the value of current tax deductions, essentially allowing you to defer income taxes on your current income until later in life when you are in a lower tax bracket.
For example, suppose you pay an effective tax rate of 25% and expect that rate to be 15% in retirement. You must contribute $5,000 in pre-tax income and this will double by the time you retire. With a Roth IRA, you would contribute $3,750 ($5,000 – 25%). When you retire, you would withdraw and keep $7,500 ($3,750*2 – 0%). With a pre-tax 401(k), you would contribute the full $5,000. In retirement, you would withdraw and keep $8,500 ($5,000*2 – 15%) since your marginal tax rate would be only 15%.
Here, the lower retirement rates would make the tax-deferred account a better option.
For a couple in their late fifties, there are a number of things to consider.
First, if you have the capacity to make both 401(k) and Roth IRA contributions, this can be a good way to build your savings and maintain some tax flexibility during retirement.
If you have to choose between a Roth IRA and 401(k), the 401(k) may be a better option. Households in their late 50s are typically at the peak of their income and, as a result, their marginal tax rate. If your income and taxes decrease in retirement, a Roth IRA may lose all of its value.
Now, households with a particularly strong 401(k) can still get real value from the tax-free, long-term gains of a Roth IRA. Let’s say you switch to maximized Roth contributions today. With 10 years of contributions and 30 years of growth, your account can grow significantly. While you’ll likely still get more value from a 401(k’s) relatively higher deductions, it’s worth considering the long-term tax-free gains.
In general, talk to a financial advisor to decide what your specific financial situation might look like. However, if you’re like most households and are preparing for retirement, continuing to save in a 401(k) may be a better choice.
For households nearing retirement, a Roth IRA can offer some strong growth opportunities and tax flexibility, but you may end up paying more taxes to build this portfolio. If you expect your tax rate to be lower in retirement, the pre-tax benefits of a 401(k) may outweigh the benefits associated with switching to Roth contributions. On the other hand, Roth accounts offer more income flexibility in retirement because RMDs are not required and distributions are tax-free.
One of the main issues with an IRA of any kind is self-management. You must open this account yourself and in most cases you must also manage its investments. That can be quite intimidating, but fortunately it doesn’t have to be that way.
A financial advisor can help you draw up a comprehensive retirement plan. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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