To Roth or Not to Roth, That is the Question
I usually tell a throwback story to start each article. But this is a lengthy article with several sections. So instead I’ll just include a cool throwback snippet from 1970 that I saw on the internet: A day after Apollo 13 lifted off, astronaut Jack Swigert realized he forgot to file his taxes. He later got an extension for being out of the country. 🙂
We just finished tax preparation and filing. We now move into tax planning for the rest of the calendar year. The concept of a Roth retirement account continues to grow in popularity with the introduction of the Roth 401k and plethora of articles about Roth IRA’s in general. Whether to contribute to a Roth is easily one of the most confusing questions facing our clients.
Because there are several different ways a person might utilize a Roth depending on their stage in life, I’ve broken this article is broken into 3 sections as follows (scroll down to the section most interesting to your situation):
I’m currently in the work force, should I contribute to a traditional 401k or a Roth 401k?
I have a traditional IRA with $200,000+. Should I convert to a Roth IRA?
I’m currently in the work force, should I contribute to a traditional 401k or a Roth 401k?
Our general rule of thumb is that, if you make more than $75,000 (single filer), or $125,000 (married filing jointly) in income, you are better off contributing to a traditional 401k to get the tax break now. Continue for a more detailed conversation…..
I’m going to start by mentioning one incontrovertible truth that confounds many people - if you contribute today to a Roth 401k rather than putting the same amount into a traditional 401k, your tax bill today WILL BE higher! Said another way, your paycheck will be smaller. How much more you pay today in taxes depends on your tax bracket.
Frankly, we get a kick out of all the articles trying to decipher whether to contribute to a traditional or Roth 401k - if your tax bracket today is the same as your tax bracket in retirement, it’s a complete wash! Yep, that’s right. If you are in the same tax bracket today as you will be in retirement, the final amount of spendable money is exactly the same. Let’s use an example: For this example, you are in the 22% tax bracket. Say you put $20,000 into your traditional, pre-tax 401k in 2024 and have 10 years to retirement. If instead you put $15,600 into your Roth 401k (remember, you would have 22% less to put in because you pay the tax up front). As soon as you retire, in year 11, you begin taking $10,000 spendable cash from the account. In 5 years, you will take out the exact same amount of cash and the money will be drained.
Investment Annual Return: 10%
Tax Bracket: 22% (during contribution years AND withdrawal years)
Deposit: $20,000 into a traditional 401k, saving $4,400 in taxes up front. OR deposit $15,600 into a
Roth 401k since the taxpayer owes $4,400 in tax up front (remember, Roth is after-tax money)
This is simply confirmation that if the tax bracket is the same during the contribution year(s) and withdrawal year(s), the account balances are exactly the same!
When does it make sense to contribute to a traditional 401k rather than Roth 401k? If you are in a higher tax bracket today than you expect to be in retirement, then you are better off in a traditional 401k. You save the tax today and agree to pay the tax when you pull the money out in retirement. Let’s say you are in the 35% tax bracket today and expect to be in the 22% tax bracket in retirement, you are better off putting your money into the traditional 401k.
Conversely, if you expect to be in a higher bracket in retirement, you are better off contributing to a Roth 401k. Why? You pay the taxes today at the lower rate. When you pull it out in retirement, you pay no tax at the higher rate.
How do you know your projected tax bracket comparison? That’s where planning comes in. Feel free to give us a call and we can set up time to do a tax planning session.
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2. I have a traditional IRA with $200,000+. Should I convert to a Roth IRA?
I’m going to start by mentioning one confusing incontrovertible truth - if you convert a traditional IRA to a Roth IRA, you will have to pay taxes in the calendar year of conversion. The income is added to your other taxable income (from wages, etc.) and taxed at your marginal tax rate.
To answer whether to convert from a Roth IRA to a traditional IRA, here are several things to consider:
Do you expect to be in a lower tax bracket later in life, when you plan to draw down the IRA? Of all the Roth conversion questions, this is probably the most valuable question as you plan a potential conversion.
Do you have cash available today to pay the taxes on the conversion.
Is there a time when your earnings will be lower when you might best be able to convert and keep your tax bracket low?
For consideration #1, the answer is similar to the decision on whether to contribute to a Roth 401k vs a traditional 401k. If the tax rate you are in today is the same as what you expect to be in during retirement, there is no value in converting. The spendable cash is the same in either case.
When does it make sense to leave the traditional IRA as it is? If you are in a higher tax bracket today than you expect to be in retirement, then the money is better off in the traditional IRA. You save the tax today and agree to pay the tax when you pull the money out in retirement. Let’s say you are in the 35% tax bracket today and expect to be in the 22% tax bracket in retirement, you are better off leaving your money in the traditional IRA.
Conversely, if you expect to be in a higher bracket in retirement, it is worth converting to a Roth IRA. Why? You pay the taxes today at the lower rate. When you pull it out in retirement, you pay no tax at the higher rate.
If you decide it is a good time to do the conversion, consideration #2 comes into play - you need to have cash available to pay the tax. We sometimes get asked if a person can simply take money out of the proceeds of the conversion. Unfortunately, unless you are 59 ½, you will owe a 10% penalty because you are taking a distribution from the IRA. In addition, using these funds means you’ve robbed your account of some of the value.
Consideration 3 - is there a time in the future when your earnings will be lower, making that time in the future ripe to make the conversion - this is an interesting planning opportunity. There might be a period after you retire, and prior to taking your IRA “required minimum distributions”, when you could do a Roth conversion. In that period, your taxable income is lower. Here is a picture to illustrate. The blue denotes income, and the green shows the amount of Roth conversion. This is an actual client. As you can see, this client is projected to have a dip in their earnings between age 70 and 75 when they could convert to a Roth and pay a lower tax bill.
This is another area where we can help with tax planning. Give us a call if you’d like us to help input your investments. We have the tools to estimate the timing when you might be able to do a Roth conversion.
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3. I’m later in life with $200,000+ in a traditional IRA. My children will inherit. Is there a strategy to convert to a Roth IRA to lower the family tax bill?
In 2019, a bill passed that changed the way inherited IRA’s are managed. Beginning in 2020, if a person inherits an IRA, and that person is not a surviving spouse, the beneficiary must liquidate the contents of an IRA in 10 years. Practically this means the beneficiary must liquidate the IRA in a finite number of years. This will raise his/her taxable income, thus incurring tax at the marginal tax rate. Let’s use an example. If Jim is married and he and his wife earn $201,000 in 2024, they are in the 24% marginal tax bracket. This means that every additional dollar of income costs them 24 cents in taxes. Let’s continue the example and assume Jim inherited an IRA from his mother and that this is year 10. This means he needs to liquidate the remainder of the IRA. If we say in the example that the IRA contained $32,000, then Jim’s income jumps from $201,000 to $233,000. He owes $7,680 in taxes upon liquidation of the IRA. Jim and his wife have incurred significant tax by having to liquidate the IRA.
Enter an interesting strategy. If adult children knew they were going to inherit an IRA from a parent, in order to pre-emptively lower their tax bill through planning, they could have their parent convert the IRA to a Roth while living. The children can pay that parent the tax bill. Let’s continue our example with Jim from above. Instead of Jim inheriting the IRA, let’s assume his mom Ruth decides to convert the $32,000 from a traditional IRA to a Roth IRA while she’s still living. Ruth and her husband are retired and their taxable income is only $60,000. They could convert the entire $32,000 to a Roth and the tax bill would only be $3,840 (the 12% tax bracket). Since Jim agreed to pay the tax, he pays his mom the $3,840 in tax, saving himself $3,840 in tax later.
When Ruth passes, Jim inherits a Roth IRA which has no rules about how quickly Jim needs to liquidate, and he incurs no additional tax.
Ruth does need to do some planning herself before she agrees to the strategy. She needs to understand her own tax brackets and where her income lies compared to the Medicare earning tables. If Ruth and her husband’s income exceeds $206,000 in 2024, their Medicare premiums go up. Therefore, Ruth should understand her estimated taxable income when considering whether to convert a traditional IRA to a Roth IRA. That’s where planning comes in. Feel free to give us a call and we can set up time to do a tax planning session.
These are 3 distinct financial planning opportunities regarding Roth vs Traditional IRA’s. If you would like to sit down to discuss these or other tax planning questions, feel free to email/text/call.
Jared
Brian Kellett, brian@kellettwealth.com. Phone 513-312-6067
Dave Bodnar, david@kellettwealth.com. Phone 513-258-6973
Jared Kline, jared@kellettwealth.com. Phone 513-768-2238
The Right Capital Roth graphic and the table were put together by me, Jared Kline. The Apollo 13 quote was published in the New York Times “timeline” email.
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