This question essentially focuses on the taxation aspects of different types of retirement accounts. When thinking about this I am reminded of an excellent book I read a few years ago called “The Power of Zero”, by David McKnight. (https://www.amazon.com/gp/product/1984823078?tag=randohouseinc30439-20).
It provides a great explanation why no one single type of retirement account can deliver the maximum tax savings you’re looking for to boost your retirement savings. For most people, the “Optimal” tax strategy is actually to have ALL THREE different types of brokerage accounts while saving for and to draw from during your retirement: Tax Free (Roth, HSA), Pre-Tax/ Tax Deferred accounts (Traditional IRA, 401-K), AND regular Taxable accounts. They each offer certain different & powerful advantages vs the other two types of accounts.
This may initially seem counter-intuitive. If you had your choice, why wouldn’t you just want 100% of your retirement savings in a Roth account?? Simple! Done!! But as it turns out, the correct answer is actually “No”, not ideally. Even taxable accounts offer certain powerful potential tax advantages which are unavailable to tax free and pre-tax retirement accounts. Each type of account can serve a different purpose, and to take advantage of some of the biggest tax breaks available in our tax code, you really need to have funds available in ALL THREE of these types of accounts.
(Full disclosure; in an earlier life I was a CPA and I’ve been a finance guy my whole career, who does our own taxes every year w/ tax software, including about 14 K-1’s on our 2023 return. But I do believe most people can understand the concepts explained clearly with examples in David’s very readable book, which was not written “for CPA’s”…)
My wife & I currently have about 12% of our retirement savings in Tax Free retirement accounts, vs 61% in Pre-Tax/ Tax Deferred retirement and the remaining 27% in regular Taxable brokerage accounts. But I plan to max out our 22% marginal tax rate bracket with Roth conversions again in 2024, and then max out our 24% marginal rate with conversion in 2025, right before the Trump tax cuts are scheduled to expire. So, by the end of next year our Tax Free accounts ratio should climb to ~ 16%, our Pre-Tax accounts will still be the majority of our savings but reduced to ~ 57%, with the remaining 27% invested in regular Taxable brokerage accounts.
It’s true that I wish I’d been a little more diligent about allocating funds to my Roth account when I was younger, so these tax-free accounts would be closer to 30% (than only 16%) by the end of 2025. A “30/40/30” allocation would seem to me to be an almost ideal relative mix of tax free, tax deferred and taxable accounts in retirement. But I’m very confident we will still have enough assets left in our taxable accounts to give us the flexibility to still take advantage of all the various (underappreciated) tax benefits which are available ONLY within taxable accounts.
Definitely Roth IRAs. I like having the earnings grow tax-free and no RMDs. I’ve been helping our grandkids invest in Roth IRAs while they are in their 20s by matching what they invest.
I was already moving rollover IRA funds into Roths up to the top of my tax bracket for general best-practice reasons, but raised-consciousness regarding RMDs to-come has made me even more diligent about it.
For most of my career I contributed to a traditional 401(k). Roth 401(k)s were not available. I did some Roth IRA contributions but that was small compared to my 401(k) plus match. In addition, conventional wisdom says your tax rate will be lower in retirement.
A couple of things happened. In the 2010’s bull market my account balance grew much larger than I anticipated. With RMDs combined with social security and pension my retirement income will exceed my pre-retirement income (yes I know, first world problem). I realized I needed to reduce my RMDs so I started Roth conversions. The other issue is the “widows tax penalty “. We currently enjoy the marriage filing jointly tax rates. For the survivor the tax liabilities increase significantly rendering the issue of tax rate arbitrage mute.
For the above reasons I am a fan of Roth accounts. I currently use them for very long term money.
If your retirement tax rate is as high or higher than your present tax rate do a Roth and sometimes even if the tax rate in retirement is less. If the tax rate is unchanged, you end up with the same amount of after tax money with a Roth or a tax deferred IRA. For example, if you are in the 35% tax bracket and invest $8,000 in a tax deferred IRA and it quadruples to $32,000 before you take it out in retirment, you then pay $11,200 in tax (still 35% bracket) and are left with $20,800 after tax. If you do a Roth you have to pay the $2,800 tax on the $8,000 and are left with $5,200 to put in the Roth. That quadruples to the same $20,800. It is also after tax money too since a Roth is not taxed. It has other advantages including no RMD and ability to grow 10 years tax free after inheritance.
If you have extra cash a Roth can often make sense even if rate will be lower in retirement especially if that money can grow for a long time. In the above example, if you can pay the 35% tax with $2,800 from a taxable brokerage account the Roth now has $8,000 that grows to $32,000 after tax. However you have lost the $2,800 that would have grown in the taxable brokerage account. Let’s say that would have also quadrupled to $11,200 and assume you only had to pay a 20% capital gains tax on the growth leaving $9,520 after tax. You are now down in the 32% rather than the 35% tax bracket. The tax deferred IRA has grown to $32,000 and is worth $21,760 after the 32% tax is paid. After tax you now have $21,760 from the IRA and $9,520 from the brokerage account for a total of $31,280 after tax. This is $720 less than the $32,000 the Roth was worth after tax! In this case even though the tax bracket in retirement fell from 35% to 32% you ended up with more money doing the Roth and all the other advantages of a Roth too!
The same is true comparing Roth and non Roth 401K and 403B as long as there is money available in a taxable account to pay the extra tax when you do a Roth rather than needing to reduce the amount you put into the Roth to have money to pay the tax. You can look at it as the difference between investing the tax money to grow tax free in a Roth versus growing in a taxed growth. The former always wins at the same tax rate in retirement and can often win even when the retirment tax rate falls.
I have been told that since I unfortunately have a mix of tax-deductible and non-tax-deductible IRAs in my Vanguard account, I cannot do a backdoor ROTH conversion. My workplace retirement account brokerage will not allow me to do a mega backdoor ROTH.
I favor stocks in the Roth IRA and cash in the regular IRA.
The hope is there will be better returns in the Roth and withdrawals wouldn’t be taxed. Also, maybe I won’t have to ever tap the Roth and my heirs will get it.
The regular IRA is the ultraconservative use it first cash account. Stocks are all the rage, but I find it difficult to believe the market can keep charging ahead as it has. I don’t want to be in the position of people I who were heavy into stocks and beginning retirement in 2008.
I have both and I have setup a mega backdoor Roth.
My strategy is to begin my 401K contributions as tax-deferred (for a given year) and if I forecast a favorable tax situation or the market drops a certain percentage, I Roth convert the tax-deferred amounts and pay the taxes.
My Roth assets are also all stocks and my tax-deferred assets are heavily bond tilted.
I really wish I had contributed to Roth 401K much sooner since I am staring at a ton of RMD I don’t anticipate I will need.
I have both. My job had a 401(a) in lieu of Social Security and a 457(b) deferred compensation plan. Both were pre-tax accounts, which I rolled into a traditional IRA when I retired.
I contributed to a Roth on my own, but it has only $173K in it. When I have to start taking RMDs from the traditional IRA it’s going to trigger the IIRMA surcharge on my Medicare premium.
Usually discussions on this topic center around tax considerations and contribution limits (in one form or another). Actually, I agree that typically those considerations should be the major focus. That said, one consideration that I rarely find mentioned is the differences in legal protections afforded between Roths, IRA’s, and other traditional retirement accounts (such as 401k’s). Suffice to say, depending on the state one resides in (or plans to reside in), anyone considering this topic should at least be aware that differences may exist and what they might mean at some point in the future. I’m a big fan of understanding as many aspects of a topic as possible before making a major decision.
I advise people to always prefer Roths. It’s only people who don’t save who might find some benefit in traditional accounts over Roth accounts, and they obviously aren’t listening to the question :-). I do, however, find that the ability to decide on a contribution after the tax year for IRAs is an excellent way to hit a tax threshhold, if that applies. Making the conversions, though, as soon as possible, as I also advise, has to be done during the calendar year.
I contribute the maximum allowable amount to my 401k on a pre-tax basis. My traditional IRA was converted to a Roth IRA in 1998. Since there is uncertainty regarding my future tax bracket in retirement, the Roth IRA provides a level of tax diversification. Income taxes, generally speaking, are relatively low now but I suspect tax rates will increase in the future.
I’d favor Roth if I met the income requirements to own one right now. Tax rates are not likely to stay this low for much longer. Additional retirement savings for me beyond 401K has to go into a taxable account. If you can afford it, having Roth and traditional IRA/401K seems ideal for managing taxes in retirement as tax policy ebbs and flows.
Think there’s a work-around for those whose income exceeds the limits … make the Traditional IRA contribution as close as possible to the end of the calendar year, then turn around and convert it to a Roth as soon as possible after the beginning of the new year. Should generally involve very little tax to pay and should be worth it for the long-term benefit over the years to follow. Picked this up from a Clark Howard broadcast, I think, some time ago and don’t ever recall seeing anywhere that’s it’s not allowed. Good luck!
Love this question. Right now we prefer Roths for two reasons that aren’t often discussed in the great Roth v. Trad debate:
As Super-Savers (meaning we max-out all available retirement accounts), we’re able to shove a bit more money into Roths because, for example, $19,000 in a Roth is actually more than the same amount in a Trad account, because the taxes have already been pad. The counter-argument you’ll hear to that is “but if you just invest the tax savings that the traditional gives you, the result is the same.” But how many people do that? I think very few. More likely people just take the money and run (or spend).
Diversification. Because in previous years the Roth 401k was not available, we have much more in traditional accounts than Roths. Given that we, like everyone else, have no idea if taxes will be higher in future than now, we’ve opted to diversify our retirement accounts. That means loading up on Roths now to balance things out.
With high 6 and sometime 7 figure income, it was much better to max out traditional 401k, which got a 50% match from my employer. No way is my income going to be higher in retirement and my RMD will not be anywhere near the $182,000 IRMAA limit for joint incomes. My income producing investments are within my $2M IRA rollover, so my taxable income isn’t impacted. My equities are all ETFs in my taxable account, so I can control my income. Converting to a Roth would just generate more taxable income so it wouldn’t be a good idea.
I don’t bother crunching the numbers too much because as with all tax policy – it will shift. I’ll have a pension, so traditional IRAs aren’t as valuable to me in retirement as someone without that income. Mostly though, I choose the Roth because I prefer to avoid deferring obligations wherever possible. Mentally, it’s just easier to not have to worry about taxes on that money, and buying enhanced peace of mind is worth it.
Whether someone should favor Roths or traditional retirement accounts depends a lot in where they are in life, their taxable income, and their current tax rate. There’s no one size fits all.
Once you retire and have an opportunity to make Roth conversions, matters get considerably more complicated. It is difficult to know if the tax arbitrage opportunity presented by conversions will work out as expected. That said, doing conversions in the name of tax diversification makes sense. Spreading assets across taxable, Roth, and traditional retirement accounts will not result in the lowest tax outcome, but it won’t result in the highest either.
I’ve not been able to contribute to a Roth for some time, but now that I am in a lower tax bracket due to a job change I am considering starting to convert some traditional IRA $ to Roth $. The tough call is knowing what tax brackets will be 25 years from now when I’d have to start drawing down my traditional IRA. Given I don’t have a crystal ball, I will be gradual about making the shift. And I’ll my conversions in such a way that I don’t tick up to a higher tax bracket.
I had a traditional IRA, and a Simple IRA at my small law practice, long before I even knew what a Roth was. But later on I started Roths for my wife and me, and in recent years have done several Roth conversions.
So, we’ve ended up with a combination. I understand (and hope) that can provide some flexibility (“tax diversification”) down the road.
When I was 18, I was all about the Roth IRA. After all, I was in a very low tax bracket while working at Publix Super Markets. I kept on the Roth train early in my career when I was working a low-salaried finance job. But then I scored a sweet gig in the energy trading industry which commanded a higher salary–so I switched to #Teamtraditional (aka regular contributions) with my 401(k). Still, I contributed to a Roth IRA since I was above the income limit for taking the Traditional IRA tax deduction.
Now, running my own business and having a Solo 401(k), I do Roth contributions for tax reasons (the small business QBI deduction essentially makes Roth 401(k) contributions more valuable).
As a general rule, if I can avoid paying 22% income tax, then I’ll do that (which means making Traditional IRA contributions). If I’m in the 12% bracket or lower, I go Roth. That’s my rule of thumb.
This question essentially focuses on the taxation aspects of different types of retirement accounts. When thinking about this I am reminded of an excellent book I read a few years ago called “The Power of Zero”, by David McKnight. (https://www.amazon.com/gp/product/1984823078?tag=randohouseinc30439-20).
It provides a great explanation why no one single type of retirement account can deliver the maximum tax savings you’re looking for to boost your retirement savings. For most people, the “Optimal” tax strategy is actually to have ALL THREE different types of brokerage accounts while saving for and to draw from during your retirement: Tax Free (Roth, HSA), Pre-Tax/ Tax Deferred accounts (Traditional IRA, 401-K), AND regular Taxable accounts.
They each offer certain different & powerful advantages vs the other two types of accounts.
This may initially seem counter-intuitive. If you had your choice, why wouldn’t you just want 100% of your retirement savings in a Roth account?? Simple! Done!! But as it turns out, the correct answer is actually “No”, not ideally. Even taxable accounts offer certain powerful potential tax advantages which are unavailable to tax free and pre-tax retirement accounts. Each type of account can serve a different purpose, and to take advantage of some of the biggest tax breaks available in our tax code, you really need to have funds available in ALL THREE of these types of accounts.
(Full disclosure; in an earlier life I was a CPA and I’ve been a finance guy my whole career, who does our own taxes every year w/ tax software, including about 14 K-1’s on our 2023 return. But I do believe most people can understand the concepts explained clearly with examples in David’s very readable book, which was not written “for CPA’s”…)
My wife & I currently have about 12% of our retirement savings in Tax Free retirement accounts, vs 61% in Pre-Tax/ Tax Deferred retirement and the remaining 27% in regular Taxable brokerage accounts. But I plan to max out our 22% marginal tax rate bracket with Roth conversions again in 2024, and then max out our 24% marginal rate with conversion in 2025, right before the Trump tax cuts are scheduled to expire. So, by the end of next year our Tax Free accounts ratio should climb to ~ 16%, our Pre-Tax accounts will still be the majority of our savings but reduced to ~ 57%, with the remaining 27% invested in regular Taxable brokerage accounts.
It’s true that I wish I’d been a little more diligent about allocating funds to my Roth account when I was younger, so these tax-free accounts would be closer to 30% (than only 16%) by the end of 2025. A “30/40/30” allocation would seem to me to be an almost ideal relative mix of tax free, tax deferred and taxable accounts in retirement. But I’m very confident we will still have enough assets left in our taxable accounts to give us the flexibility to still take advantage of all the various (underappreciated) tax benefits which are available ONLY within taxable accounts.
Roth no RMD’s and withdraw when you want and need
Definitely Roth IRAs. I like having the earnings grow tax-free and no RMDs. I’ve been helping our grandkids invest in Roth IRAs while they are in their 20s by matching what they invest.
I was already moving rollover IRA funds into Roths up to the top of my tax bracket for general best-practice reasons, but raised-consciousness regarding RMDs to-come has made me even more diligent about it.
For most of my career I contributed to a traditional 401(k). Roth 401(k)s were not available. I did some Roth IRA contributions but that was small compared to my 401(k) plus match. In addition, conventional wisdom says your tax rate will be lower in retirement.
A couple of things happened. In the 2010’s bull market my account balance grew much larger than I anticipated. With RMDs combined with social security and pension my retirement income will exceed my pre-retirement income (yes I know, first world problem). I realized I needed to reduce my RMDs so I started Roth conversions. The other issue is the “widows tax penalty “. We currently enjoy the marriage filing jointly tax rates. For the survivor the tax liabilities increase significantly rendering the issue of tax rate arbitrage mute.
For the above reasons I am a fan of Roth accounts. I currently use them for very long term money.
If your retirement tax rate is as high or higher than your present tax rate do a Roth and sometimes even if the tax rate in retirement is less. If the tax rate is unchanged, you end up with the same amount of after tax money with a Roth or a tax deferred IRA. For example, if you are in the 35% tax bracket and invest $8,000 in a tax deferred IRA and it quadruples to $32,000 before you take it out in retirment, you then pay $11,200 in tax (still 35% bracket) and are left with $20,800 after tax. If you do a Roth you have to pay the $2,800 tax on the $8,000 and are left with $5,200 to put in the Roth. That quadruples to the same $20,800. It is also after tax money too since a Roth is not taxed. It has other advantages including no RMD and ability to grow 10 years tax free after inheritance.
If you have extra cash a Roth can often make sense even if rate will be lower in retirement especially if that money can grow for a long time. In the above example, if you can pay the 35% tax with $2,800 from a taxable brokerage account the Roth now has $8,000 that grows to $32,000 after tax. However you have lost the $2,800 that would have grown in the taxable brokerage account. Let’s say that would have also quadrupled to $11,200 and assume you only had to pay a 20% capital gains tax on the growth leaving $9,520 after tax. You are now down in the 32% rather than the 35% tax bracket. The tax deferred IRA has grown to $32,000 and is worth $21,760 after the 32% tax is paid. After tax you now have $21,760 from the IRA and $9,520 from the brokerage account for a total of $31,280 after tax. This is $720 less than the $32,000 the Roth was worth after tax! In this case even though the tax bracket in retirement fell from 35% to 32% you ended up with more money doing the Roth and all the other advantages of a Roth too!
The same is true comparing Roth and non Roth 401K and 403B as long as there is money available in a taxable account to pay the extra tax when you do a Roth rather than needing to reduce the amount you put into the Roth to have money to pay the tax. You can look at it as the difference between investing the tax money to grow tax free in a Roth versus growing in a taxed growth. The former always wins at the same tax rate in retirement and can often win even when the retirment tax rate falls.
I have been told that since I unfortunately have a mix of tax-deductible and non-tax-deductible IRAs in my Vanguard account, I cannot do a backdoor ROTH conversion. My workplace retirement account brokerage will not allow me to do a mega backdoor ROTH.
I favor stocks in the Roth IRA and cash in the regular IRA.
The hope is there will be better returns in the Roth and withdrawals wouldn’t be taxed. Also, maybe I won’t have to ever tap the Roth and my heirs will get it.
The regular IRA is the ultraconservative use it first cash account. Stocks are all the rage, but I find it difficult to believe the market can keep charging ahead as it has. I don’t want to be in the position of people I who were heavy into stocks and beginning retirement in 2008.
I have both and I have setup a mega backdoor Roth.
My strategy is to begin my 401K contributions as tax-deferred (for a given year) and if I forecast a favorable tax situation or the market drops a certain percentage, I Roth convert the tax-deferred amounts and pay the taxes.
My Roth assets are also all stocks and my tax-deferred assets are heavily bond tilted.
I really wish I had contributed to Roth 401K much sooner since I am staring at a ton of RMD I don’t anticipate I will need.
There is a school of thought out there that Roth’s are not a true cure-all for everyone.
I have both. My job had a 401(a) in lieu of Social Security and a 457(b) deferred compensation plan. Both were pre-tax accounts, which I rolled into a traditional IRA when I retired.
I contributed to a Roth on my own, but it has only $173K in it. When I have to start taking RMDs from the traditional IRA it’s going to trigger the IIRMA surcharge on my Medicare premium.
I thought of doing a Roth conversion but haven’t.
I now look back and would have post taxed contributions to my 401k and put much more in my Roth 401k. Now I’m looking at moving this a Roth Ira.
Usually discussions on this topic center around tax considerations and contribution limits (in one form or another). Actually, I agree that typically those considerations should be the major focus. That said, one consideration that I rarely find mentioned is the differences in legal protections afforded between Roths, IRA’s, and other traditional retirement accounts (such as 401k’s). Suffice to say, depending on the state one resides in (or plans to reside in), anyone considering this topic should at least be aware that differences may exist and what they might mean at some point in the future. I’m a big fan of understanding as many aspects of a topic as possible before making a major decision.
I advise people to always prefer Roths. It’s only people who don’t save who might find some benefit in traditional accounts over Roth accounts, and they obviously aren’t listening to the question :-).
I do, however, find that the ability to decide on a contribution after the tax year for IRAs is an excellent way to hit a tax threshhold, if that applies. Making the conversions, though, as soon as possible, as I also advise, has to be done during the calendar year.
I contribute the maximum allowable amount to my 401k on a pre-tax basis.
My traditional IRA was converted to a Roth IRA in 1998.
Since there is uncertainty regarding my future tax bracket in retirement, the Roth IRA provides a level of tax diversification. Income taxes, generally speaking, are relatively low now but I suspect tax rates will increase in the future.
I’d favor Roth if I met the income requirements to own one right now. Tax rates are not likely to stay this low for much longer. Additional retirement savings for me beyond 401K has to go into a taxable account. If you can afford it, having Roth and traditional IRA/401K seems ideal for managing taxes in retirement as tax policy ebbs and flows.
Think there’s a work-around for those whose income exceeds the limits … make the Traditional IRA contribution as close as possible to the end of the calendar year, then turn around and convert it to a Roth as soon as possible after the beginning of the new year. Should generally involve very little tax to pay and should be worth it for the long-term benefit over the years to follow. Picked this up from a Clark Howard broadcast, I think, some time ago and don’t ever recall seeing anywhere that’s it’s not allowed. Good luck!
Love this question. Right now we prefer Roths for two reasons that aren’t often discussed in the great Roth v. Trad debate:
With high 6 and sometime 7 figure income, it was much better to max out traditional 401k, which got a 50% match from my employer. No way is my income going to be higher in retirement and my RMD will not be anywhere near the $182,000 IRMAA limit for joint incomes. My income producing investments are within my $2M IRA rollover, so my taxable income isn’t impacted. My equities are all ETFs in my taxable account, so I can control my income. Converting to a Roth would just generate more taxable income so it wouldn’t be a good idea.
I don’t bother crunching the numbers too much because as with all tax policy – it will shift. I’ll have a pension, so traditional IRAs aren’t as valuable to me in retirement as someone without that income. Mostly though, I choose the Roth because I prefer to avoid deferring obligations wherever possible. Mentally, it’s just easier to not have to worry about taxes on that money, and buying enhanced peace of mind is worth it.
Whether someone should favor Roths or traditional retirement accounts depends a lot in where they are in life, their taxable income, and their current tax rate. There’s no one size fits all.
Once you retire and have an opportunity to make Roth conversions, matters get considerably more complicated. It is difficult to know if the tax arbitrage opportunity presented by conversions will work out as expected. That said, doing conversions in the name of tax diversification makes sense. Spreading assets across taxable, Roth, and traditional retirement accounts will not result in the lowest tax outcome, but it won’t result in the highest either.
I’ve not been able to contribute to a Roth for some time, but now that I am in a lower tax bracket due to a job change I am considering starting to convert some traditional IRA $ to Roth $. The tough call is knowing what tax brackets will be 25 years from now when I’d have to start drawing down my traditional IRA. Given I don’t have a crystal ball, I will be gradual about making the shift. And I’ll my conversions in such a way that I don’t tick up to a higher tax bracket.
I had a traditional IRA, and a Simple IRA at my small law practice, long before I even knew what a Roth was. But later on I started Roths for my wife and me, and in recent years have done several Roth conversions.
So, we’ve ended up with a combination. I understand (and hope) that can provide some flexibility (“tax diversification”) down the road.
When I was 18, I was all about the Roth IRA. After all, I was in a very low tax bracket while working at Publix Super Markets. I kept on the Roth train early in my career when I was working a low-salaried finance job. But then I scored a sweet gig in the energy trading industry which commanded a higher salary–so I switched to #Teamtraditional (aka regular contributions) with my 401(k). Still, I contributed to a Roth IRA since I was above the income limit for taking the Traditional IRA tax deduction.
Now, running my own business and having a Solo 401(k), I do Roth contributions for tax reasons (the small business QBI deduction essentially makes Roth 401(k) contributions more valuable).
As a general rule, if I can avoid paying 22% income tax, then I’ll do that (which means making Traditional IRA contributions). If I’m in the 12% bracket or lower, I go Roth. That’s my rule of thumb.