When in Doubt, Roth it Out
When choosing what kind of retirement account to use, it’s hard to go wrong with a Roth IRA or Roth 401k.
This blog post represents my opinion and should not be considered investment advice. Consult with an investment advisor or financial planner for advice pertaining to your situation.
Are you someone who has wondered about opening a traditional or Roth IRA but hasn’t because you’re not sure which to choose?
Or maybe you’ve been looking at your 401k options and don’t know if you should open the traditional or Roth 401k?
Here’s the thing: if you go online and ask Google which one you should have, nearly every piece of advice out there says that you should open a traditional IRA or 401k if you anticipate being in a lower tax bracket in retirement than you are now, and to select the Roth version if you think you’ll be in a higher tax bracket in retirement (if you’re eligible based on income).
How the hell are you supposed to know that?!?!
For those of you I’ve already lost, tax brackets get higher as you make more money. So the more money you make, the higher the percentage of your income gets taxed (unless you have a team of experts helping you legally or illegally avoid taxes, of course).
Personally, I’m happy to pay taxes to fund education, public healthcare, good roads, and more. But whether you support taxes in theory or not, it’s always a good idea to engage in smart tax planning.
For most people, this involves retirement accounts. (Super rich people have designed the laws to offer themselves many many opportunities to reduce their taxes, but us regular people don’t need to worry about that right now.
So how do you do smart tax planning when you don’t know what bracket you’ll be in?
When in doubt, Roth it out.
(This phrase probably only makes sense in my own head. It is a modification of another personal motto I have: when in doubt, throw it out. This keeps my hoarding tendencies in check.)
The point is that a Roth version is almost always going to be the best option.
Why you should choose a Roth
In order to understand why a Roth is a good idea, you have to understand the difference between traditional 401ks/IRAs and the Roth version.
Traditional 401k and IRAs
Traditional 401k and IRA contributions are made with money that has NOT been taxed.
For example, let’s say you’ve told your employer to send 10% of your income to your 401k and your salary is $50,000. $5000 for that year goes to your 401k. This reduces your taxable income to $45,000. You haven’t paid income tax on that $5000 yet. It gets to grow and grow and grow until you finally reach retirement age, at which point you have to start withdrawing the money. Now the money is taxed.
(Putting money in an IRA gets the same tax treatment, although it usually involves reducing your taxable income through a tax deduction when you file your taxes. Also note that there may be income restrictions.)
Money withdrawn from your 401k or IRA in retirement counts as ordinary income and will be taxed at the tax rate for your income level. Remember, 401ks and IRAs are subject to RMDs (Required Minimum Distributions), so you HAVE to take this money out of your retirement account. You can’t just let it sit there and grow forever.
Roth 401ks and Roth IRAs
Roth 401k and Roth IRA contributions are made with money that HAS already been taxed.
So in the example above, your total $50,000 salary is subject to income taxes in the year you earn it. Then you make your contribution out of that already-taxed money.
Because you’ve already paid tax on that money, it will not be taxed when you withdraw the money in retirement. This is a major tax benefit.
If you’d like to see the numbers for how this might work for you, check out this calculator from Charles Schwab.
What’s the worst that could happen if you pick a Roth IRA and end up having a higher tax bracket now than later?
Well, you might not have made the most of your tax situation, but you’ll still have a healthy retirement account and will be able to withdraw the money tax-free when you need it. Wouldn’t it be great to not pay income taxes in retirement?
And really, the most important part of saving for retirement is actually making the contributions, not where you put the money.
(Note: Roth 401ks are subject to RMDs, but they can be easily converted to a Roth IRA, which does not require you to withdraw money—another awesome Roth IRA benefit.)
What if I think I might have less income and be in a lower tax bracket when I’m retired?
This is a valid concern, and for some people that might be true. But there are a few things to consider:
1. Many people reach retirement and end up making more even though they never expected it. I know multiple people who diligently saved over the years and then ended up making more than they did before they were retired. This could happen due to things like:
Getting married and having a combined income in a higher tax bracket
A spouse dying: when one spouse dies, the surviving spouse now has to pay taxes at a higher rate as a single person.
You’ve saved so much that you just have a lot more money than you’d ever imagined you could have.
You get a pension and end up with more income than you anticipated.
The people I know in this situation are now in a place where a Roth would have been beneficial. They don’t need the money they have to withdraw as RMDs and would have been happy to let it grow to pass to their grandchildren. Instead, they have to take their RMDs, potentially being pushed into a higher tax bracket and having to pay more for things like Medicare.
2. We never really know what the tax rates will be in the future. Some people are convinced they will go up, others are not. Nobody really knows. So you have to realize that you are always just going to do your best with the best information you have. Focus on having a solid saving strategy, not fortune-telling.
3. Picking a Roth and ending up in a situation where it wasn’t the best tax decision is still not a bad situation to be in.
If you have more solid reasons to think that you might be better off with a traditional IRA, it’s worth talking to a financial planner about your specific situation. You’ll also want to consult a financial planner if you’re thinking about doing any sort of backdoor Roth conversion (where you take money from an IRA, pay taxes on it, and move it to a Roth IRA).
An advisor can help you look at your whole situation, including your life goals, and help you design the best overall strategy for you.
Related Article: 401k Tips to Maximize Your Retirement Savings
Final Thoughts
Those who are young and eligible for Roth IRAs or Roth 401ks can generally feel confident when choosing the Roth option.
So if you’ve been letting your anxiety or uncertainty about opening the right type of account hold you back, get off your a$$ and go open a Roth. Or just starting contributing something to some type of account somewhere. Anywhere (well, maybe not anywhere, but you know what I mean).
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