For the right person, a Roth IRA can be a fantastic long-term retirement savings. So much so that it seems to some that it is always the right choice, no matter what. After all, tax-free income is great. However, as with anything else in your retirement planning journey, this decision on pre-tax versus after-tax contributions should consider the nuances of your specific situation.
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How to Consider Pre-vs. Post-Tax Contributions
The key advantage of a pre-tax traditional IRA is that you can invest more money over time. In theory, all the money you save from pre-tax contributions is available as capital for further compounding gains.
The key advantage of a Roth IRA is that you can save on taxes in retirement, compared to pre-tax accounts where taxes are simply deferred. With this, you will eventually pay income tax on both contributions and returns. With post-tax accounts like a Roth IRA, you don’t pay anything on your returns because you’re already taxed on your contributions.
For example, say you want to invest $1,000 from your paycheck, but pay an effective tax rate of 20%. With a Roth IRA, you pay $200 in taxes first, then invest the remaining $800. With an IRA, you save that $200 in taxes and can invest the entire $1,000.
Then, let’s say this account doubles in size and you withdraw it. Your Roth IRA grows to $1,600 and you keep all of it. Your IRA grows to $2,000 and you pay $400 in taxes, again leaving you with $1,600 after taxes. (Note that this situation is simplified for demonstration purposes.)
So, how do you choose? You’re usually better off choosing based on when you expect to pay a higher tax bill.
More specifically, if during your current working years you pay more in taxes than you expect in retirement, then a traditional IRA can help you wait on taxes and deduct the Your contributions are currently better in theory. If you pay a higher tax rate during retirement, then Roth IRA tax-free withdrawals may be better.
Using our example above, say you invest $1,000 while working and make 100% returns by the time you retire. Let’s also assume that while working, you pay 20% in taxes, and then pay 10% when you withdraw in retirement. At retirement, your balance will be $1,600 in a Roth IRA versus $2,000 in a traditional IRA. But then accounting for taxes, your Roth withdrawal would cost $1,600 tax-free, while your traditional IRA withdrawal would cost $1,800 after deducting 10% of the tax from your balance. Again, because you pay more taxes while working, a traditional IRA is better.
On the other hand, say you pay 20% in taxes now and pay 30% when you withdraw the money in retirement. Then, your after-tax Roth withdrawal will still be worth $1,600, but your traditional IRA withdrawal will only be worth $1,400 after the 30% tax rate. In this reverse case, you’re better off with a Roth IRA.
Should You Pivot Roth Contributions?
Keep in mind that a Roth IRA has a cooldown, because you can’t withdraw earnings from your Roth IRA for five years after you create it (although you can withdraw your original contributions ). Unless you’re planning an early retirement, this probably won’t be an issue, but it’s worth keeping in mind.
As always, if you plan to make similar contributions despite the tax benefits, you may do well to switch to a Roth portfolio. You want to let this money sit there for a while, but with $2.5 million in your 401(k), someone could theoretically afford it. Make your Roth contributions, leave them there until you’re 80 and collect those 20 years of tax-free growth later in life.
If not, you’ll want to compare tax rates. Because of your 401(k) balance, right now you’re probably at or around the peak of your career-high earnings. So the odds are that you are paying a higher tax rate now than when you retire.
It’s common to make pre-tax 401(k) and IRA contributions more valuable than a Roth IRA, because you get more from the investable capital versus the future tax savings. However, if you expect to pay higher taxes once you retire, future savings in a Roth IRA may outweigh your 401(k) investment opportunities.
Should You Switch to Roth Contributions or Roll Over Your Account?
Finally, there’s always the Roth IRA rollover option.
Transferring contributions at age 60 raises two specific issues. With only a few years left until you retire, your 401(k) will outperform any Roth IRA you can build, meaning you’ll still pay taxes on most of your retirement savings. You can also contribute until age 50+ to the Roth IRA maximum catch-up, which is $8,000 for 2024 and pales in comparison to the annual limit of $30,500 for a 401(k).
A rollover would fix both of those issues.
With a Roth IRA rollover, you move all or part of your money from a pre-tax retirement portfolio into a Roth IRA. You can then make new contributions to this account, or you can contribute the entire $30,500 to your 401(k) and annually roll the assets into a Roth IRA.
However, remember that you will have to pay tax on the full amount of your rollover. Doing it all at once, that means adding $2.5 million to your taxable income the year you roll over your 401(k). Before making a move like this, however, it’s probably a good idea to discuss it with a financial advisor.
At age 60, moving your retirement contributions to a Roth IRA may not have many benefits. But this can depend on a number of factors, particularly your total contributions and how your tax rate changes from work to retirement.
Roth IRA Rollover Tips
A financial advisor can help you create a comprehensive retirement plan. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free initial call with your advisor matches to decide who you feel is right for you. suits you. If you’re ready to find an advisor who can help you achieve your financial goals, get started today.
If you want to roll your 401(k) into a Roth IRA, there are several moving pieces you need to pay attention to. Read SmartAsset’s comprehensive guide to learn more.
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