For the right person, a Roth IRA can be a fantastic retirement savings vehicle over the long term. So much so that it might seem to some that it's always the right choice, no matter what. After all, tax-free income does sound pretty great. However, like anything in your retirement planning journey, this decision on pre- vs. post-tax contributions will require delving into the nuances of your specific situation.
Do you have questions about planning out your retirement contributions? Speak with a financial advisor today.
How to Consider Pre- vs. Post-Tax Contributions
The key advantage to a pre-tax traditional IRA is that you can invest more money over the long run. In theory, all the money you save from pre-tax contributions is capital available for further compounding gains.
The key advantage to a Roth IRA is that you save on taxes in retirement, as compared to pre-tax accounts where those taxes are only deferred. With these, you eventually pay income taxes on both contributions and returns. With post-tax accounts like a Roth IRA, you pay no money at all on your returns because you’ve already been taxed on your contributions.
For example, say that you want to invest $1,000 from your paycheck, but pay an effective tax rate of 20%. With a Roth IRA, you would first pay $200 in taxes, then invest the remaining $800. With an IRA, you would save that $200 in taxes and can invest the full $1,000.
Then, let's say that this account doubles in size and you withdraw it. Your Roth IRA would grow to $1,600 and you would keep all of it. Your IRA would grow to $2,000 and you would pay $400 in taxes, leaving you again with $1,600 after taxes. (Note that this situation is simplified for the purposes of demonstration.)
So, how do you choose? You will usually be better off picking based on when you expect to pay higher tax rates.
More specifically, if during your working years you currently pay more in taxes than you expect to in retirement, then a traditional IRA's ability to help you wait on taxes and deduct your contributions in the meantime would theoretically be preferable. If you will pay a higher tax rate during retirement, then a Roth IRA's tax-free withdrawals may work better.
Using our example above, say that you invest $1,000 while working and make 100% in returns by the time you retire. Let’s also assume that while working, you paid 20% in taxes, and then pay 10% when you’re withdrawing in retirement. At retirement, your balances would be at $1,600 in a Roth IRA versus $2,000 in a traditional IRA. But then accounting for taxes, your Roth withdrawal will be worth $1,600 with no taxes, while your traditional IRA withdrawal will be worth $1,800 after subtracting 10% in taxes from your balance. Again, because you’re paying more in taxes while working, a traditional IRA is much more ideal.
On the other hand, say that you pay 20% in taxes currently and will pay 30% when you withdraw the money in retirement. Then, your after-tax Roth withdrawal will still be worth $1,600, but your traditional IRA withdrawal will be worth just $1,400 after a 30% tax rate. In this inverted case, you'd be better off with the Roth IRA.
Should You Pivot to Roth Contributions?
Remember that a Roth IRA has a cooldown, as you can't withdraw earnings from your Roth IRA for five years after you make them (though you can withdraw your original contributions). Unless you plan on an early retirement, this probably isn’t an issue, but it's worth noting.
As always, if you plan on making the same contributions regardless of tax benefits, you might do well switching to a Roth portfolio. You'll want to let this money sit there for a while, but with $2.5 million in your 401(k), someone could theoretically afford that. Make your Roth contributions, let it sit there until you're 80 and collect that 20 years of tax-free growth later in life.
Otherwise, you’ll want to compare tax rates. Given your 401(k) balance, right now you're probably at or around the peak of your career-high earnings. So the odds are that you pay a higher tax rate now than you will in retirement.
Typically that will make pre-tax 401(k) and IRA contributions more valuable than a Roth IRA, since you'll get more out of the investible capital compared with the future tax savings. But, if you expect to pay higher taxes once you retire, a Roth IRA's future savings might outweigh your 401(k)'s investment opportunities.
Should You Switch to Roth Contributions or Roll Over Your Account?
Finally, there's always the Roth IRA rollover option.
Switching contributions at age 60 raises two specific issues. With only a few years left until you retire, your 401(k) would significantly outweigh any Roth IRA you could build up, meaning you'll still pay taxes on most of your retirement savings. You also can only contribute up to the Roth IRA's age 50+ catch-up maximum, which is $8,000 for 2024 and pales in comparison to the annual limit of $30,500 for a 401(k).
A rollover can fix both of those issues.
With a Roth IRA rollover, you move all or part of your money from a pre-tax retirement portfolio into a Roth IRA. Then you could make new contributions into this account, or you could contribute the full $30,500 to your 401(k) and each year roll those assets into the Roth IRA.
However, remember that you would then need to pay taxes on the entire value of your rollover. Doing it all at once, that would mean adding $2.5 million to your taxable income in the single year you rolled over your 401(k). Before making a move like this, though, it would probably be a good idea to discuss it with a financial advisor.
At age 60, switching your retirement contributions to a Roth IRA might not have a lot of benefits. But it can depend on a lot of factors, especially your total contributions and how your tax rates will change from work to retirement.
Roth IRA Rollover Tips
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
- If you do want to roll your 401(k) into a Roth IRA, there are a lot of moving pieces that you need to pay attention to. Read SmartAsset’s comprehensive guide to learn more.
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