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Insights from The Mind Money Spectrum Podcast Episode #30
As a fee-only fiduciary financial advisor, my mission is to help high-performance professionals achieve financial security and freedom through smart, actionable strategies. One powerful tool I often recommend, but also closely analyze, is the Roth account—whether that’s a Roth IRA or a Roth 401(k). While the advice to “just contribute to a Roth IRA” is widespread online, understanding the nuances behind why a Roth might be beneficial—or when it might not be the best fit—is key to truly turbocharging your retirement goals.
In this article, I will walk you through the critical concepts and practical steps surrounding Roth accounts. I’ll focus on how you can make them work for your unique situation, including when to consider a Roth conversion, the differences between traditional and Roth accounts, and why combining Roth strategies with accounts like HSAs can multiply your benefits.
Understanding Traditional vs Roth: The Tax Timing Game
The fundamental difference between a traditional retirement account (IRA or 401(k)) and a Roth lies in when you pay taxes. Traditional accounts operate on a tax-deferred basis: you contribute pre-tax dollars, lowering your taxable income now, and pay ordinary income tax when you withdraw funds in retirement. Roth accounts flip that on its head—you contribute after-tax dollars (meaning you’ve already paid income taxes), but qualified withdrawals in retirement are completely tax-free.
Here’s a simple example: Let’s say you have $6,000 to save. If you put it into a traditional IRA, you get a $6,000 tax deduction this year, but must pay income tax on the entire withdrawal amount later. If you put that same $6,000 in a Roth IRA, you pay taxes now on the $6,000, resulting in less take-home pay, but the money grows and eventually comes out tax-free.
What does that mean for you? If your tax rate today is about the same as in retirement, the math works out to be roughly the same whether you choose Roth or traditional. However, since predicting future tax rates is nearly impossible, the general rule of thumb is to choose the type of account that aligns with where you expect your tax rate to be:
- If you expect your tax rate to be lower in retirement than it is now: A traditional account may make more sense.
- If you expect your tax rate to be higher or the same in retirement: A Roth account often offers superior benefits.
For many younger professionals early in their careers, Roth accounts tend to be advantageous because income (and thus tax rates) tend to be lower now than at retirement. Also, Roth accounts benefit from tax-free compounding growth, which, over decades, can make a substantial difference.
Contribution Limits and Income Restrictions: What You Need to Know
Currently (as of 2020 data), the contribution limits for IRAs are $6,000 per year (or $7,000 if you are age 50 or older). However, Roth IRAs have income limits on who can contribute directly:
- Single filers making over $139,000 (MAGI) cannot contribute directly to a Roth IRA.
- Married filing jointly with income over $206,000 is excluded from contributing directly.
These income limits are where the traditional vs Roth analysis gets a bit trickier for higher earners. If you make too much to contribute directly, there are strategies to still fund a Roth IRA, such as the Backdoor Roth IRA, which I’ll explain below.
Also, remember that your spouse can contribute the same amount to their own IRA, effectively doubling your household’s potential tax-advantaged savings.
Roth 401(k) vs Roth IRA: Employer Plans and Flexibility
Many employers now offer a Roth 401(k) option alongside the traditional 401(k). The Roth 401(k) allows you to contribute after-tax dollars just like a Roth IRA but comes with much higher contribution limits—$19,500 per year (plus a catch-up contribution if you’re over 50, currently $6,500).
Some reasons to consider a Roth 401(k):
- Higher contribution limits: Save more in tax-advantaged dollars compared to a Roth IRA.
- Employer match: Although matches go into traditional pre-tax accounts, it’s essentially free money you don’t want to miss.
- No income limits: Unlike Roth IRAs, Roth 401(k)s don’t have income restrictions, so high earners can contribute post-tax dollars.
Between the two, the Roth 401(k) is often the more powerful savings vehicle simply due to the higher limits. That said, the Roth IRA offers more investment flexibility, especially if you want to manage investments beyond what your employer’s plan offers.
Backdoor Roth IRA: How High Earners Can Benefit
For professionals making too much to contribute directly to a Roth IRA, there is a strategic workaround called the Backdoor Roth IRA. The process goes like this:
- Make a nondeductible contribution to a traditional IRA (the money is after-tax since you don’t get a tax deduction).
- Immediately convert that traditional IRA balance to a Roth IRA.
Because you never took a deduction, you owe little to no taxes on the conversion. This approach lets you bypass the Roth IRA income restrictions though it relies on precise timing and IRS rules.
Important caveat: If you have other traditional IRA balances, the conversion can become pro-rated, and taxes might be owed on some portion. This makes it vital to plan carefully with an advisor.
Roth Conversions: Timing Your Tax Bill to Your Advantage
Another powerful technique is to convert traditional IRA or 401(k) assets to Roth accounts strategically over time. Conversions trigger a tax bill on the amount converted, but if done when your income (and therefore tax rate) is lower—think sabbatical, job loss, or early retirement years before Social Security benefits kick in—you can pay taxes at a discounted rate.
This creates tax-free Roth balances that can grow for years before you withdraw, helping you reduce future required minimum distributions (RMDs) from traditional accounts and minimizing your taxable income in retirement.
Example: If you expect a year where you earn less income, a Roth conversion can convert part of your traditional IRA funds, paying taxes now at a lower rate instead of later at a higher rate.
Required Minimum Distributions (RMDs) and Roth Benefits
Traditional IRAs and 401(k)s require you to take RMDs starting at age 72, forcing you to pull money out and pay taxes even if you don’t need the cash. Roth IRAs, in contrast, do not have RMDs during your lifetime. That means your Roth assets can continue growing tax-free longer and be passed on to heirs with favorable tax treatment.
One strategic consideration is to do partial Roth conversions before age 72 to reduce your future RMD amounts and the accompanying tax hit.
Health Savings Accounts (HSAs): The Retirement Bonus
While not strictly a retirement account, HSAs deserve a mention when discussing tax-advantaged savings. Funded with pre-tax dollars, growing tax-free, and with tax-free withdrawals for qualified medical expenses, HSAs offer a triple tax advantage. Plus, after age 65, you can withdraw from an HSA for any purpose without penalty—though if not used for medical costs, withdrawals are taxed as ordinary income.
For professionals with high-deductible health plans, maximizing HSA contributions (up to around $7,000 for families) can be a powerful complement to retirement savings strategies.
Practical Steps to Turbocharge Your Retirement with Roth Accounts
- Maximize your 401(k) employer match first: This is free money and should never be missed.
- Evaluate your tax bracket now and your expected tax rate at retirement: If you believe your tax rate is lower now, favor Roth contributions to lock in tax-free withdrawals.
- Contribute to Roth accounts when eligible: Roth IRAs if your income allows, Roth 401(k)s if offered by your employer.
- Consider backdoor Roth contributions if over income limits: Work with an advisor to ensure proper execution.
- Use Roth conversions strategically: Convert traditional assets after a year of lower income or before RMDs start to reduce future tax bills.
- Fund your HSA fully if possible: This can ease healthcare costs in retirement and supplement your tax-advantaged savings.
- Plan holistically: Consider all your accounts, investment strategies, and retirement income needs—not just Roth vs traditional.
Conclusion: The Roth Isn’t Always The Default, But Often a Game-Changer
The Roth IRA and Roth 401(k) are powerful tools that, when used thoughtfully within a broader financial plan, can turbocharge your retirement savings and offer valuable tax flexibility. The key is understanding the trade-offs and tailoring your approach based on your current financial situation and future tax outlook.
By taking advantage of employer matches, knowing when to contribute to Roth and traditional accounts, and employing strategies like backdoor Roths and conversions, you can maximize your savings and enhance your financial freedom in retirement.
If you’re a high-performance professional seeking retirement security and flexibility, working with a fiduciary advisor who understands the nuances of Roth strategies along with the full range of investment options is the best way to unlock the full power of these accounts and stay on track for your goals.
For more detailed guidance customized to your unique situation, consider scheduling a consultation to explore how the Roth account and retirement planning strategies can work in your favor.
Originally published on July 7, 2020.
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