By Howard Pressman, CFP®
Egan, Berger & Weiner, LLC
Roth accounts are a great way to build flexibility into your retirement income planning because they trade tax benefits today for tax benefits in the future. To make the most of them, it’s best to start planning long before retirement.
A Brief Primer:
When you make a contribution to a Traditional IRA or 401(k) it is done before tax, meaning that you usually get a tax deduction equal to your contribution. As an example, Susan, a 40-year-old architect, makes $100,000 and elects to contribute $18,000 to her 401(k).
When Susan files her taxes, she’ll deduct the contribution amount from her income, reporting only $82,000. While in your 401(k), your money will grow tax-deferred, meaning you’ll pay no taxes on the growth. However, when you begin taking money out of this account, you will pay ordinary income taxes (the highest of your tax rates) on the entire amount withdrawn.
So let’s assume you pay 33 percent in combined federal and state taxes and that you want to withdraw money from your 401(k) to buy something that costs $100. How much would you have to withdraw? If you said $150, you’re correct. That’s 50 percent more than what you need to spend! Since 33 percent of $150 is $50, which goes to Uncle Sam, withdrawing $150 leaves you with $100 to spend.
In contrast, with a Roth account you’ll receive no tax deduction today (when you make a contribution), your money will still grow tax-deferred, and when you begin withdrawing money, it all comes out completely tax-free! How great is that? Of course you’ll have to meet certain requirements, but that’s not hard.
Roth accounts are fantastic strategies for younger investors — especially those in lower tax brackets. They’ll have lots of time for this money to grow tax-free, and assuming they’ll be in higher tax brackets as their income climbs, they’ll be paying taxes on the money they contribute to it at their lower rate today, instead of at their higher rates in the future.
Let’s get back to Susan: Assuming she continues to contribute $18,000 to her retirement account each year, she’ll have $1,444,034 saved. Regardless of whether she chose the Traditional pre-tax 401(k) or a Roth 401(k), the accumulated value will be the same. Now that she’s retired, Susan can begin taking distributions from her retirement savings so she can travel the world and learn to speak Italian.
Both accounts could likely provide her with an income of approximately $104,000 per year according to the American Funds’ Traditional vs. Roth Analyzer. But Susan will owe Uncle Sam a piece of each Traditional withdrawal. After paying taxes of $26,000 on the $104,000, Susan is left with $78,000 to spend. Had she chosen the Roth 401(k), Susan would enjoy the entire $104,000, as no taxes are owed.
To be fair, what about all the taxes Susan would have saved by taking the deduction during her working years? Well, had she saved this money in an investment account (as we wish everyone would), Susan could likely get another $16,800 a year from this pool of money. Combining the distributions from her Traditional IRA ($78,000) with the “side” investment account ($16,800) totals $94,800 — still $9,200 per year less than with the Roth. Clearly Susan would be wise to consider the Roth 401(k).
Those closer to retirement or even in retirement should also consider the benefits of a Roth account. By building flexibility into how you construct your income in retirement, you’ll have better control over your expenses. We’ve already seen that when you withdraw funds from a Traditional IRA, you must withdraw 50 percent more than you need to spend to cover your taxes.
What happens when the government says you must begin taking money out of a Traditional IRA — whether you need to or not?
- Under the current IRS rules, you must begin taking distributions from your Traditional IRA and 401(k) assets at age 70½. (The amount you’ll have to take is determined by a table created by the IRS.)
- Many retirees who’ve saved very well find they don’t need this money to meet their needs. Unfortunately, you must withdraw the minimum required amount and pay whatever taxes are owed on it.
- This additional income pushes some folks into higher tax brackets, meaning that even less of the money withdrawn is available to spend after taxes.
Roth IRAs, on the other hand, have no required minimum distributions during your lifetime, and can even help keep your Medicare premiums from increasing.
For example, Medicare Part B and D premiums can be affected by increased income due to large Traditional IRA or 401(k) distributions. Under current rules, if you’re single or widowed and have modified adjusted gross income (MAGI) that exceeds $85,000, your Medicare Part B premium will increase from $104.90 a month to $170.50 — a 62 percent increase!
If your MAGI exceeds $107,000 but is less than $160,000 your premium skyrockets to $243.60 per month. What’s more, included in the so called “Doc Fix” legislation signed into law last year is a new Medicare income level that will begin in 2018 and kick in at $133,500 for singles or widows. Exceed this new level and your premiums will skyrocket to more than $300 per month!
Because your Roth IRA distributions are not taxable, they don’t count towards MAGI, and will afford you better control over your Medicare premiums.
Should You Consider Converting a Traditional IRA to a Roth?
Obviously laws will change and no one can predict the future, which is why it makes sense to build flexibility into your retirement income plan. The challenge, however, is that Roth IRAs have only been around since the late 90s and the Roth 401(k) since 2006, so most people close to or in retirement have the majority — if not all — of their retirement savings in Traditional IRAs or 401(k).
This can limit your flexibility in retirement and potentially increase your expenses, as a result of higher taxes and health insurance costs. In these instances, converting Traditional IRA assets into Roth IRA assets may be recommended.
Under this conversion strategy, you will have to pay taxes on the amount converted, but once the money has been deposited into the Roth you will enjoy all the benefits it has to offer.
There is a lot to consider when developing a flexible retirement income strategy, so if you’re interested in how a Roth may fit into your plan, we’ll be happy to show you.
As always, if you have questions about your retirement or any other financial matter, please reach out to your EBW financial adviser or Idelis Favole at firstname.lastname@example.org.