To Roth or not to Roth?

A discussion I often have with my clients, especially as we get closer to the end of the year, is around the topic of Roth accounts. While many have heard of them and have a vague sense that “it’s a good thing to do”, there is often a lack of clarity of what they are and why we would do it. So, what are they and is this something that makes sense for you?

What are Roth Accounts

When we contribute to retirement accounts, we usually use the traditional flavor of these accounts. Whether we save using our workplace pre-tax 401k plans or on our own make deductible contributions to our IRAs, the concept is the same. The money we put into the accounts is pre-tax, will grow within the account without being taxed up until the point when we start taking withdrawals. At that point, the whole amount which includes both contributions and the growth of the investments, is subject to tax. Each time we take a withdrawal, the amount we withdraw in effect gets added to our income and gets taxed at our overall income level.

If we instead contribute to a Roth account, we flip when we pay the taxes to the beginning. When we contribute, we use after-tax dollars to fund the account. The money grows within the account until the point that we want to start withdrawing. Two main differences to point out with respect to traditional accounts - the Roth account which includes both the contributions and the growth of the investments is not subject to tax, assuming certain timing/age guidelines are followed. Second, we take money out of the Roth accounts when we want to. Roth accounts do not have the same requirements of having to take a certain amount out of the account each year once you reach a certain age (required minimum distributions or RMDs). (Roth 401k accounts currently require RMD withdrawals but this ends in 2024).

Why Roth Accounts

How do you choose which type of account is better for you? The main difference to consider is when you pay the taxes. With traditional accounts, you push off paying the taxes until retirement and with Roths, you pay the taxes upfront. An incorrect assumption many have is that your tax bracket will always be lower in retirement. Your “income” in retirement is typically made up of a few components – your social security benefits, any pensions you may have and the required minimum distributions from your traditional IRA accounts. For those who have been fastidious savers your whole careers, there could be significant balances in your traditional accounts which in turn can result in large RMDs.

The obvious advice – the optimal time to pay taxes is when you are in a lower tax bracket. If you have that prescience of what taxes will look like in the future, the decision which style of account to use is clear. However, most people obviously don’t. Not only do we not know what our future tax bracket will look like, we also do not know what overall tax brackets will look like. What we can do is to employ a strategy to try to diversify our tax buckets, much like we diversify our investments. If we can build a bucket of after-tax money to go along with our pre-tax bucket that would let us in effect hedge our overall taxes. There are certain years when we may end up at lower brackets – for example in years when we are not working or are earning lower salaries – these could be times where we elect to pay taxes on a portion of the funds in our pre-tax accounts to take advantage of lower tax brackets.

How to Roth

Many times, when I bring up the topic of Roth contributions with clients, their initial response is that they are not eligible because of their salaries. Let’s go over the different ways of getting money into Roths:

• Roth IRA contributions – Each year, the amount you can contribute is set by the IRS. For example, for 2023 the contribution limit is $6500 for those under 50 and goes up to $7500 for age 50 or older. There are income restrictions. First you must have earned income at least equal to the amount you are contributing. However, if your earned income is over a certain amount, for example $153,000 for single filers or $228,000 for married filing jointly, you cannot contribute at all. This is the case that many think makes them ineligible to get funds into a Roth.
• Roth 401k contributions – If your company offers this 401k option, you can contribute up to the same annual limit ($22,500 under 50, $30,000 for those 50 and older) directly into your Roth 401k. There are no income restrictions.
• Roth conversions – With money in traditional IRAs and potentially some traditional 401ks (the latter is based on if your plan allows), you can convert some or all of those funds into a Roth account. In effect, you are deciding to pay the taxes now (hopefully in a lower tax bracket, as outlined above) and let the money grow tax-free and be withdrawn tax-free in the future (again following certain timing guidelines).

Does it make sense for me?

The answer is different for everyone, and a thorough review of your personal situation will help determine the best tax planning strategy. By empowering yourself with the knowledge and taking the time to plan, you can help set yourself up for overall success.

Raymond James and its advisors do not offer tax advice. This information is intended to be educational and is not tailored to the investment needs of any specific investor.Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion. Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.