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If I save on an after-tax basis in a 401k, (plan permitting) the earnings, upon distribution, are taxed as ordinary income and subject to RMDs. However, withdrawing my after-tax contributions only count toward the RMD until they are exhausted. If I save after-tax in a Roth account, the earnings are tax-free with no required withdrawals.
There are earnings limits on contributing to a Roth, but no income or account balance limits on Roth conversions.
Roth distributions are excluded from MAGI and thus substantial income may not count toward IRMAA premiums, but that’s not the case for tax-exempt Muni bond interest also purchased with after-tax money. In theory you could have a $1 million in Roth income and avoid IRMAA. What a deal!
Pre-tax 401k contributions are subject to FICA taxes, but pre-tax cafeteria plan contributions (IRC Section 125) are not. Generally, there are no income limits using a Section 125 plan. Such plans could modestly lower future Social Security benefits or some workers.
If there is any logic here, it escapes me.
My first thought was some rules are to prevent extra benefits for high income workers, but that is not case, especially for Roth conversions.
The goal is to encourage retirement savings and make it more feasible – I assume. Is it working? Not to the extent hoped. How much is all this encouragement costing?
All this may be moot for most Americans if Congress doesn’t get cracking on making both Social Security and Medicare sustainable.
Then there is the possibility that the lost revenue from tax-free programs like Roth get the attention of the current wave of cost cutters. If health insurance premium subsidies get discussed – and they are – why not Roth freebies?
I bet the majority of Americans couldn’t make heads or tails of your post.
I bet you are right.
Some people are focused on maximizing their retirement income and reducing taxes. Delaying Social Security and doing Roth conversions can be good tools to accomplish these things. Everyone’s situation is different. There are no hard and fast rules for all. Nobody should be judged on their personal choice.
I was able to take advantage of my Roth when I was diagnosed with a life-threatening illness. I made a withdrawal so we could relocate and to cover unexpected expenses. There were no taxes on the money withdrawn. That was a good thing. The excess has been saved in a taxable account. If I had not had the Roth, I would have taken a larger withdrawal from my Traditional account.
This is a mischaracterization of Roth IRAs. They are not freebies. The tax is paid upfront. They are designed to produce identical results as a traditional plan assuming the same inputs. Traditional plans have RMDs because no taxes have been collected on the account; Roth has no RMDs because the tax has already been paid.
Post-tax contributions in IRAs are treated by the same pro-rata rule that is used for pensions and annuities that have post-tax contribution. The post tax contributions are distributed pro-rata and not considered taxable income. You likely could have rolled your post-tax 401k amounts into a Roth IRA.
MAGI is basically AGI plus tax-exempt interest added back in. Roth distributions have already been taxed, so it’s not the same as muni interest. Roth distributions are not considered taxable income.
ROTH earnings haven’t been taxed. Couldn’t the earnings actually exceed the contributions?
Of course it can. Have low value privately held stock in a Roth when the company goes public and the stock value sky rockets. We’ve all read about it in the news. Earnings are large and not taxed.
Okay, that’s a good question RQ, and RC has a great answer. What I don’t understand are all the down votes.
I don’t understand most of the down votes I get. I thought it was a basic question.
I don’t think anyone deserves a down vote on HD. Some sites I can understand it. Perhaps the down vote is a feature that could be removed? The Fidelity forum removed it. SeekingAlpha needs a down vote.
I would probably favor that. At least one person seems to down vote everything I write, however bland.
That one was me. JUST KIDDING Kathy. I like all you posts.
The down arrows would probably stop if it showed who marks it that way. At Fidelity, it shows who gave a “kudo” to any comment. Before Fidelity removed the ‘down’ feature it did show who marked it that way. You really get to know a personality of someone who consistently is negative. I also think it might be of value on HD if it showed who marks an up arrow.
That’s a good idea
That is incorrect. They are effectively taxed upfront. Do the math and you will see.
For example – invest $10,000 pre-tax at 8% return for 30 years, 20% tax rate. Withdrawal total amount after 30 years.
Trad IRA – $10,000 grows to $100,626.57. After 20% tax, you would get $80,501.26 (Tax bill = $20,125.31)
Roth IRA – Same $10,000 is taxed at 20%, or $2,000. Invest $8,000 after tax, After 30 years at same rate balance is $80,501.26 Same amount.
The $2,000 income tax at the beginning would grow to $20,125.31 had it been invested. So the earnings not invested in a Roth are equal to the tax at the withdrawal form a Trad IRA. That’s how it was designed.
This assumes the tax rates are the same at the beginning and end of the 30 year period. Depending on that, you may be better off with a Trad or Roth.
Your math is flawless. However, I would like to point out that having a Roth in parallel with a Trad IRA allows you to stack the deck so that the math can make your Roth relatively more valuable over time.
When i began my Roth journey at age 58 20 years ago, I had 100% of my retirement account in my Trad IRA. Between age 58 and age 69, when I started SS, I had converted 41% of my age 58 Trad IRA value. I made these conversions by transferring equity ETF shares from the Trad IRA to the Roth. Now 20 years later, the total value of the two accounts equals 2.25X the age 58 account value. However, the Roth represents over 54% of the total value. Of course since age 70.5 I have been doing RMDs as well.
So, today, when you look at my asset allocation, you see that the Roth is 100% equities, and the Trad IRA is 100% bonds. So, if as we all assume, equities continue to grow faster than bonds, the Roth balance will continue to be a larger and larger % of the total value of the two accounts. And, every year, My RMD is only 46%(or less) of what it would have been without the conversions.
However, you must do the math to see if doing a conversions is right for you. Today, if you retire before Medicare eligibility, you have to negotiate your health insurance. With 30 years at my employer, i enjoyed retiree medical coverage. I think this is mostly no longer available. Additionally, until beginning SS, we lived on investment income, and withdrawals from our taxable account, and some inheritance $$. So, our tax bracket was low.
Depending on who will ultimately be withdrawing funds from the Roth, it might be advantageous to do conversions even when the apparent tax rate seems higher. If your children are going to be the probable recipients, and IF they are very successful and you know they will be paying tax at a higher rate than your current bracket, from a family wealth point of view, doing conversions now might be a good thing to do.
And, let us not forget that there are many, many widows and widowers out there who will out live their dead spouses for a significant time. Paying tax as a single person is going to be painful experience for the survivor.
Rick, thank you for the straight-forward example. It is very easy to forget about the lower tax load many years ago when we were in our best earnings years and opted for the traditional 401K ticket as we had plenty of uses for that “temporarily saved” money (4 teenage kids).
Currently, we have a mixed asset bag of a cash based trading account, traditional IRA account, we each have a small Roth IRA and a bucket of cash for large “out-of-left-field” events and less than ideal markets over several years. It’s been rather agonizing trying to determine if we should convert or not, as we’re really not looking forward to the ordinary income tax aspect for now. Yea far, this mix has been working well.
Fortunately, the markets have been providing for good growth on the cash trading account and it’s been a bit nicer utilizing the LTG tax rates for now. What we’ve been skimming off the account – to pay for a new vehicle, pay off the mortgage and help our kids financially while we’re around, bulking up the emergency fund, etc. – keeps growing back. Bigger picture, the only benefit of converting at some time (per my understanding) would be the treatment/distribution of the accounts for our beneficiaries. Not really sweating the possibility of my wife dealing with too much income from RMD’s should I check out first. So with no idea what the future holds in tax policy, the economy, etc, just keeping calm and carrying on and looking forward to starting my 66th trip around the sun in a few weeks.
Cheers!
I would suggest checking out the RMD calculators at both Maxifi and Boldin websites to see if one of those would help you decide. Each of those websites have a different philosophy looking at retirement plans.
Thank you, David.
I’d still invest $10,000🤑 Like a Roth conversion paying taxes but not out of the converted funds.
You certainly could, but you would then use $12,500 in the Trad calculation. The specific numbers change, but not the end result or conclusion.
Rick, i don’t dispute your calculations, but isn’t this a little like the maximize lifetime SS argument?
In the aggregate a retire may not be ahead tax-wise, but they do get tax-free income at the time they may need it most.
Like do i want most monthly SS income when most needed or to be sure over 20-25 years i collect the maximum.
I have no idea what this means. I was just trying to demonstrate that Roth IRAs are taxed, just differently than Trad IRAs.
Seems like a bait and switch on people.
How do you figure that? If the tax deduction on the traditional IRA is the present value of the future tax bill on withdrawals, assuming the same tax rate, it’s financially equivalent to a Roth.
Dick: You often disparage strategies employed by others that you didn’t use. I gather you never funded a Roth or undertook a Roth conversion. Do you think you made a mistake? Do you think that makes you biased against Roths? I sense the same bias against delaying Social Security until age 70 — a strategy many experts recommend but one you never used.
Exactly. I believe Dick has Roth envy.
I think few people using IRAs take the time to think about or understand Ricks calculation just assuming that a Roth is always a good deal. That’s what I was referring to.
I’m not disparaging anything. My post was pointing out the variable and confusion people face.
I think one of the most underrated benefits of Roth conversions earnings is their being untaxed for decades, and inheritance of the asset.
My wife is 66 her mother is 103. If my wife lives to the same age, that is 37 years of tax free earnings. If the rules are the same from now until 10 years after she dies and my children don’t touch the funds until then that is 47 years of tax free earnings.
If the fund was even only 100k today, 100% in Vanguard Total World ETF, (which it is currently) since inception the historic return of the mutual fund iteration’s (used this as it is equivalent as it has been in existence longer) of 8.62% the balance at withdrawl would be $4,872,595 TAX FREE
If you aren’t being disparaging, why are you calling it a bait-and-switch?
On the part of Congress – creating something of apparent value that may not be for many people as Rick demonstrated.
I didn’t attempt in any way to show that Roth accounts have no value. I was just trying to demonstrate how they are taxed. I believe both Trad and Roth accounts have significant value. I believe that saving for retirement is the most important thing. Which type of account you choose is secondary – you can be successful with either. Given the uncertainties in future tax rates and life long earnings, a mix of the 2 might make sense. John Yeigh’s recent article did an excellent job discussing the two types of accounts.
You could say the same about traditional retirement accounts. The bait is the initial tax deduction at your current income-tax rate — but the result can be withdrawals at an even higher tax rate.
Yup, it’s just that tax-free earnings sounds appealing
And an immediate tax deduction doesn’t?
You’re right Rick, I have never looked at it that way. The only thing i might add is that for someone with a more modest retirement income, Roth distributions might not increase tax on SS benefits.
Things are looking like nothing will increase the tax on Social Security benefits because there won’t be any.
Dan, very true. The basic tradeoff with Trad and Roth accounts is do you pay the tax now or later, There can be lots of reasons to choose one or the other. But you pay taxes either way.
Very nice explanation!
If I might add, a benefit offered by the Roth is eliminating uncertainty. Once you pay those taxes you know that more taxes aren’t forthcoming and on a trad IRA they can be variable (current tax rates plus the possibility of changing from married to single levels).
I think of it as a secondary benefit as it clearly doesn’t change the rate of return. Instead it benefits one’s state of mind.
My question is do ROTHs count as a revenue loss to government?
Dan has stopped shouting Roths but now Dick has started?
They seem to think “Roth” is an acronym of some sort, rather than the surname of a former senator from Delaware.
Ed Slott had a recent article that stated that Congress loves Roth’s because they bring in immediate revenue.If half of 401k participants switched to Roth accounts, wouldn’t that subject significantly more income to income tax immediately? I found a statistic that stated that in 2020 tax preferred retirement savings cost the government $189B. Switching from a traditional to a Roth would provide an immediate increase in tax revenue.
While a goal may be to encourage saving for retirement, the government exists at cross-purposes. One purpose is to collect money from us. Government is inefficient at best and so why would one ever think that our patchwork tax code is rational? Nor do I have any illusions about the benevolence of government. I’ve saved for retirement in tax-advantaged accounts, a Roth-IRA, a brokerage account, simple savings, etc. Like a squirrel, I’ve buried a lot of nuts. I’ve always assumed that at some point the government will find a way to tax everything, including the Roth. However, the current programs (Roth, 401k, etc.) are working to the extent that if they didn’t exist, I suspect even more of us would avoid saving for retirement. I concluded long ago that I if I saved at all I would pay taxes. Some today and some tomorrow. It has been pointed out elsewhere that the best way to avoid taxes is to not have assets or income. That’s not a path I chose to take.
Given that Roth has been available since 1998, more than 25 years ago, everyone has had the opportunity to participate if they chose to do so. You could have done Roth conversions and then you would also be enjoying this benefit. And, even though Roth distributions don’t count in IRMAA, I think most folks with Roth accounts are not taking them……so, there isn’t any “income”.
Are you saying ROTH accounts are a tax scam because retirees don’t actually use them as income? Better not say that too loud. 😎
my husband and I have doing large Roth conversions for about ten years. The money we convert each year counts as income and we pay the tax on that; it also figures into our IRMAA so our Medicare premiums are very high. We plan to leave the Roths to our kids, but I don’t see how we’re shirking taxes. Also what about the tax benefits of QCDs, qualified dividends, stepped up value of second homes, tax free interest?? I see no reason to single out Roths as “unfair.”
Every legal tax avoidance technique should be used. My point was that if ROTHs are accumulated but not used for retirement income that was not the intent of Congress. If most people don’t use them as intended, why have them? I suspect most people do use them though.
I don’t understand your rationale. The treatment of both traditional and Roths is the same for beneficiaries— empty them within 10 years. Doesn’t that suggest both kinds of accounts could be left as inheritance and not used to fund retirement?
I simply doubt the intent of Congress was to help build estates and leave legacies. Thats why the ten year rule was implemented.
So maybe I should just buy a Mercedes or two instead of using my money to fund the Roth conversions.
I wouldn’t they depreciate 🤑