When it comes to saving for retirement, Roth accounts can make a significant impact on how much control you have over your income and taxes. Here is what you need to consider when deciding where to put your retirement savings.
A brief history lesson
The idea of retirement used to be significantly different. In the days when pensions were normal, people used to put in a career with a company and then after 30 years, they were given a retirement party, a gift and a paycheck for the rest of their life. This may be over dramatized, but the point is that today the working experience is different and we are largely expected to rely on our own savings for our retirement income.
Company retirement plans began changing to defined-contribution plans in the late seventies. The introduction of the 401(k) was a change to employees taking on the risk of investing their retirement savings vs. the company providing a pension. This change was also motivated by a much different tax environment. Consider that in 1978 there were 26 different tax brackets if you were married filing jointly. The highest marginal rate was 70% for a household making over $203,000. Today we have 7 tax brackets with the highest rate being 37%.
In the late seventies if an individual was making a decent wage and they expected to be able to live on less in retirement, it made sense to lower their taxable income and pay taxes later. Enter the 401(k) and the Traditional IRA. Today, there may not be an advantage of deferring taxes to later.
Pre-Tax Savings
When you put money into your 401(k) or traditional IRA, you reduce your taxable income by the amount you put into the retirement account. This gives you a tax benefit today. This also means that the money enters the account without being taxed. As your money is invested it grows tax-deferred. This means that you do not have to pay taxes on your investment income and gains when they are earned. Then, when you withdraw money in the future, the amount withdrawn is considered income and is taxable.
Is this still effective?
A lot has changed since the seventies. Here are some considerations that may make pre-tax savings less effective:
The current tax brackets may make it more difficult to see significant savings by paying taxes later.
Our current idea of retirement is evolving. Many people used to envision lower expenses in retirement, however today we are not seeing as drastic of a change in income needs. More retirees are carrying debt, continuing to pay for aging parents or adult children, or seeing higher healthcare costs. The result is that retirees are needing to maintain similar incomes as they were in their working years.
Government spending continues to grow. While it is impossible to know how tax policy will change in the future, many people believe higher taxes will be passed on to future generations.
The Roth difference
The Roth IRA or Roth 401(k) allows you to contribute after tax money to your retirement account. Since this money is taxed before it goes into your account, you will not have to pay taxes later. You don’t get any tax advantage today, but you also know exactly what tax rate you are in today. The money is invested and grows tax-deferred just like a traditional IRA. The big difference is that when you withdraw money, it is completely tax-free. This means that you never pay taxes on your investment earnings. This is a huge deal when it comes to accumulating future wealth!
Required minimum distributions
Another key difference between Roth and traditional retirement savings is the requirement to withdraw your money. Under traditional accounts, the IRS requires you to begin withdrawing income when you turn 70 1/2 (There is current legislation trying to change this to 72, but it hasn’t passed yet.). This ensures the government that you will withdraw the money and pay taxes. The formula is set to determine your required distribution and you essentially lose a bit of control over how you withdraw your money.
The Roth is not subject to these requirements. This means that you control when you withdraw your money and how much you withdraw. If you don’t need the income, you can continue to let the money grow without taxes on your earnings.
Controlling your tax rates
There are two scenarios where the Roth can really be a gamechanger for your retirement.
First, when you have significant Roth savings you can control how much of your future income is subject to tax. Since we don’t know where tax rates are going in the future, building a tax-free income source gives you the ultimate control of your future tax payments.
Second, if you need to withdraw large sums of money in retirement, tax-free money makes the most sense. Many retirees have plans to buy that vacation home, RV, or just plan a big trip. It may be a necessity like a new roof or a medical bill. When you need to pay for large expenses, taking money out of a traditional retirement account can drain your nest-egg. Since the entire amount is taxable to you as income, a large withdrawal can cost almost twice as much when you consider the taxes. Likewise, if you have a significant amount of money in a regular brokerage account or mutual fund, when you sell that investment to withdraw money, you will most likely pay a big capital gains tax. The Roth gives you the advantage of taking large withdrawals without tax consequences.
Other key things to know:
The maximum annual contribution to a 401(k), Roth or Traditional, for 2019 is $19,000. If you are over 50, you can add an additional $6,000 for a max of $25,000. This will increase by $500 for both in 2020. Making the normal limit $19,500 and the catch-up $6,500 for a total of $26,000.
The maximum annual IRA contribution (traditional or Roth) is $6,000. If you are over 50, you can add an additional $1,000 for a limit of $7,000. This will remain the same for 2020.
Roth and traditional contributions have restrictions based on income. It is important to review your personal circumstances to know what is best for you. We can create a customized plan for your retirement savings and analyze what benefits a Roth may have for your future.