Inevitably, one of the topics brought up during a conversation with any financial planner is how to save money on taxes. Of course, if you have a significant tax “problem” you also have a very positive situation on your hands: A healthy six or seven-digit income (just trying to look on the bright side here!).
Actual tax savings or deferral?
The financial profession, from advisors to accountants to money coaches, has largely trained clients (and the general public) to seek out the maximum tax savings possible in any given year. Nothing wrong with that. One of the most common ways to achieve a tax deduction is using tax-deductible retirement account contributions, either through an IRA or pre-tax 401(k) contribution. You may be making contributions to one of these types of accounts currently.
While it’s true that these accounts offer a current year tax deduction, they are not really saving you money on your tax bill, they are merely deferring your taxes owed on that income to a future date. This is a key distinction. At a minimum, the IRS requires you to begin withdrawing from these accounts once you’ve reached age 70.5 and the withdrawals will be taxed at ordinary income tax rates.
You are essentially making a trade and a tax bracket assumption. The trade: Avoid taxes now, pay taxes later. The tax bracket assumption: My tax rate will definitely be lower in retirement than it is now.
When $100k is really only $75k
But is taking a tax deduction always the preferred route when making retirement account contributions? Have you considered that in retirement, nearly every dollar you use to fund your lifestyle will be taxed? IRA withdrawals? Taxable income. 401(k) withdrawals? Taxable income. Social security checks? Taxable income (up to 85% of total benefit). Consider the following: A $75,000 annual retirement lifestyle is closer to $100,000 of total income/withdrawals when using a combined (federal and state) tax rate of 25%!
Is there an alternative? Some way to save and invest your way to a tax-free retirement option? Enter, the Roth account. The two retirement accounts you can use to effectively accomplish this are the Roth IRA and the Roth 401(k) account. Both accounts allow you to contribute on an after-tax basis, rather than pre-tax (i.e. you do not receive a current year tax deduction when you contribute to these accounts). In both accounts, any growth or earnings can be withdrawn tax-free once you reach age 59.5.
The key differences are these: (1) The Roth 401(k) is only available through employer-sponsored retirement plans. Roth IRAs do not require an employer-sponsored plan. (2) The Roth 401(k) allows you to contribute $18,500 per year or $24,500 if you are age 50 or older (2018 limits). In the Roth IRA, you can only contribute $5,500 per year or $6,500 per year if you are age 50 or older (2018 limits). (3) There is no income limit when making Roth 401(k) contributions. You can earn any amount and be eligible to make Roth 401(k) contributions. With Roth IRAs, there are income restrictions. However, it’s still possible for high-earners to use a Roth IRA using professional guidance.
So why would you make Roth contributions? In short, you do this to tax diversify your retirement money. You and I have no idea what tax bracket you will be in 20-40 years from now. There is no possible way to know what IRS tax rates will be or what kind of financial situation you will experience that far into the future. However, prudent planning would suggest that you prepare yourself to have options when withdrawing from your retirement accounts. The Roth IRA and Roth 401(k) accounts allow you to make tax optimal decisions in retirement rather than just pray and hope that IRS tax rates go down and your personal financial situation puts you in a lower tax bracket, multiple decades from now.
If you are currently used to getting a tax deduction for your retirement contributions, changing to Roth will feel like a pay cut (since with Roth, you are now paying taxes on your contributions AND making the contribution). One option to help begin tax diversifying your retirement could be to take your current contribution, say 10%, and split it 5% pre-tax contribution and 5% Roth contribution. Remember, any matching contributions that your employer may contribute to your account are pre-tax in nature and you will end up paying taxes on those monies upon withdrawal.
How Roth helps you save more
Here’s a great example of how switching to Roth contributions could help you save more towards retirement:
Traditional IRA maximum contribution: $5,500 (tax-deductible), helps you reduce your current year taxes by $1,375 ($5,500 times 25% assumed combined tax rate). On a “net” basis however, you are really only investing $4,125 after-tax ($5,500 contribution minus the $1,375 of taxes you would otherwise pay). And for sake of the example, we’ll assume that like most people, you’ll likely spend that tax savings rather than re-invest it in other investments!
Roth IRA maximum contribution: $5,500 (after-tax), which does not reduce your taxable income. This means you are actually contributing $7,333 of your gross income, which, after paying taxes (again assuming 25% tax rate) results in $5,500 available for a Roth contribution. The Roth option, in effect, helps you save $1,833 more than the Traditional IRA contribution ($7,333 vs. $5,500).
What makes sense for you?
Of course, consult with your tax advisor or financial planner before you make any changes to your accounts. Realize that switching to Roth won’t help you “save” on taxes in the near-term. But it will help you tax diversify your retirement accounts, enable you to save more into qualified retirement accounts, and build up a tax-free retirement account option.
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