I’ve asked about this before, got confused and frustrated, and eventually abandoned any hope of understanding.
I’m ready to try again.
Let’s start with this very basic question (more will come later):
As I understand it, with a Roth you are contributing dollars that have already been taxed. When the time comes to withdraw (retirement), you retrieve your money with no tax implications.
In a non-Roth 401k, you contribute non-taxed dollars. Decades later, you retire and draw on your saved funds but they are taxed.
So far, so good?
Now, my simpleton understanding of the process tells me that a working stiff contributing to an IRA would generally pay more taxes while working than he would in retirement, because he would presumably have a higher income while working than he would as a retiree and therefore be in a higher tax bracket.
I know I am generalizing, and I know there are always exceptions. But if what I say is mostly true, why would a Roth make sense for anyone? Won’t I, as a retiree with a very modest income, pay less tax in my golden years than if I had paid my tax back in the day when I was earning substantially more?
Basically, you came to the same conclusion that I did. However, you are leaving out a large part of the calculation. While a Roth vehicle does not offer tax free contributions, it does offer tax free accumulation. That means that all the money that is earned is not taxed and will never be taxed while everything you withdraw from a traditional IRA (401K) gets taxed. While you may pay a lower rate on those withdrawals, more money will end up being taxed.
Executive Summary:
An regular IRA is money you deposit into it and take a tax deduction for it. When the money is taken out when you retire, it is taxed.
A ROTH IRA is money you deposit into it, but take no tax deduction for it. When the money is taken out when you retire, it is not taxed.
A 401(k) is money that is deposited into the plan by your employer on your behalf, and this amount lowers your taxable income. So you pay less in taxes now. When the money is taken out when you retire, it is taxed just like a regular IRA.
The assumption is that when you retire, you won’t have any other sources of income other than Social Security so you will be at a lower tax bracket. But meanwhile, the money sitting in those accounts has been earning money without you paying taxes on it along the way. So when you take the money out, you should be paying less taxes on it. That’s the tax intention behind those investments for retirement.
But that might not always be the case for everyone. Say you continue to earn an income your entire life, but start taking money out of your regular IRA or 401(k) past age 70, it is questionable if you would be at a lower tax bracket. In fact, you might be at a higher one.
But the truly big reason these were setup as retirement investments with regard to taxes is to encourage the population to save money for retirement. Because Social Security isn’t intended to be your only source of income in retirement. I know there are people who claim you can live just with Social Security but for most people that simply wouldn’t be enough when you take into consideration the cost of living in many places.
To answer your question about the ROTH IRA. A ROTH IRA gives no tax deduction on the contributions to it, and that’s usually because lower income people either pay no or very little in federal income taxes. So a tax deduction to them doesn’t mean very much or anything at all. So the payback to encourage them to save, because this is what it is all about, is that when they take the money out when they retire they don’t have to pay any taxes on it. The rationale for that is because they didn’t get a deduction from taxes when they put the money in.
Now you might wonder, why do I need a ROTH IRA, and not just a simple savings account in a bank or a brokerage account, and the reason is that any interest or dividends made on that money would be taxed each year. So money in a ROTH IRA grows tax-free while in a regular bank account or brokerage account you’d have to pay tax on interest and dividends.
And generally lower income people use a ROTH IRA because getting a tax deduction from a regular IRA offers them nothing or very little, and they would still end up paying taxes on it when they take it out at retirement.
Because not everyone has access to a 401K plan. Or because they’ve maxed out contributions to their 401K but still want to put more away. Or because they like the idea that they can withdraw the amount of their original contributions to a Roth (in some cases under age 59) without having to pay tax on it.
So it isn’t really a case of either/or, but more of a question of what mix of 401K/Roth IRA/Traditional IRA you qualify for, and works best both currently and after retirement.
I have an IRA that I funded with a total of $40,000. It is now worth $400,000. I will be in the 10% tax bracket at age 70 when I start spending it down. I will pay $40,000+ in taxes if I live long enough.
I also have a Roth IRA that also started with $40,000 but I was in the 20% tax bracket, so I really started with $50,000 - I had to pay $10,000 in taxes. It too is worth $400,000 but no taxes are due - even if I leave it to my daughter.
I’m well past 59 1/2 but under 70. What I’ve been doing is taking some money out of my 401K in amounts that won’t increase my bracket all that much and moving it to a Roth IRA. That both reduces what I’ll have to withdraw after 70, and makes the earnings of this money not taxable. I expect to be accumulating it for a long time. That’s especially useful since I’ll be getting more Social Security once I hit 70 and move from taking spousal benefits from my wife to my own much higher benefits.
People might be interested to know that the RMD (Requirement Minimum Distribution) on the regular IRA at age 70 1/2 doesn’t apply to the ROTH IRA. So if you don’t need the money, you don’t need to take it out of a ROTH IRA and can leave it in there invested. That’s because the IRS won’t be collecting taxes on it, so they don’t force you to take the money out.
Excellent, clear replies, all. I have a better understanding already.
I am 60, retiring in 5 years. My current contribution to my 401k is 28% of my gross income.
None of my 401k is in a Roth. At this point, should I switch all or some of my future contributions to a Roth? Or am I too late for that to be any benefit?
Also, can I convert portions of my already existing savings into a Roth (I know I would have to pay the taxes)? Is there a limit to how much you can convert?
mmm
(A) Congress tinkers with the tax code all the time.
(B) Right now, tax rates are near historically-low rates.
20-40 years from now, when you’re ready to retire, which is more likely–that tax rates will be lower than they are right now, or that they’ll be higher?
Supplemental question–do you suppose that Congress may not get around to adjusting the tax brackets for inflation?
Supplemental question #2–is it not true that many people have various tax deductions (dependent children, mortgages, etc.) during their working years that they will NOT have during retirement?
Do you now begin to see why your assumption is a very questionable thing?
You are 60 years of age, so you can max your 401(k) contribution to $24k per year. When you do this, it lowers your taxable income so you can an immediate benefit that can be worth thousands to you right now. You figure that amount X 5 years and that can be a real tax break. A 401(k) is better than an IRAs because there is a chance your employer can make a matching contribution to your 401(k) which is essentially free money. 401(k) have a much higher contribution limit, I think it is $53K a year, where IRAs are limited to $6500.00 a year.
I wouldn’t convert to a ROTH IRA because you will be paying taxes on that amount now. You will loose the benefit of what the current money in there can grow over the next five years. You only do ROTH IRA if you either can’t get a tax deduction worth anything, or you don’t qualify for doing a regular IRA to take a deduction. If you can’t take the deduction for a regular IRA then you do a ROTH. If you know what your income is going to be for the tax year you can even change a ROTH IRA to a regular IRA by doing what is called a recharacterization. You ask the brokerage/banker to do this for you, and it can only be done during that tax calendar year.
If I may, I would like to point out that the OP asked a question concerning a Roth 401(k).
Many of the responses have begun mixing in the concepts of Roth IRAs, which are a completely different thing and may be confusing to people who are already confused about things.
I recognize that Roth 401(k)s are relatively new and many (most?) of your employers may not offer them yet (or ever). But please be careful in your answers not to confuse things further for the OP.
I do not know about Roth 401(k)…never knew they existed.
I did have similar questions recently looking in to a Roth IRA and was told there is a reason the contribution is capped at $6,000/year ($6,600 over 50). The tax implications are so favorable that without a cap everyone would put all their money in to one.
The 2018 limit for 401(k) deductible contributions and Roth 401(k) contributions for those over age 50 is $24,500.
Employers can also match contributions to Roth 401(k) plans. However, employer matching contributions and the earnings thereon are considered before-tax funds and will be taxed upon distribution.
For 2018, the maximum 401(k) contribution limit is $55,000. This is known as the “Section 415(c) limit.” This includes employer and employee contributions to both 401(k) and Roth 401(k) accounts. It includes non-deductible employee contributions to a traditional 401(k) account. It does not include the $6000 catch-up contribution for employees over age 50. Note that unlike the $24,500 limit, this is per plan, not per employee. An employee with multiple employers can reach this limit at each unrelated employer.
I may be misinterpreting, but I think that he was suggesting converting from a 401(k) to a Roth 401(k).
I don’t understand why you say this.
No. There are many reasons to do a Roth IRA. But his question was not about Roth IRAs, it was about Roth 401(k)s.
A Roth (IRA or 401(k)) will save you money if your tax rate goes down in retirement. A Roth also has no RMDs. Being forced to take an RMD at an inopportune time can drive up your tax bracket.
The question is, of course, whether you can accurately predict your future tax rates.
You can’t actually recharacterize your Roth IRA or regular IRA. You can recharacterize the current year’s contribution and (with limits) the previous year’s contribution, not the entire account (unless all you have is one year’s contribution in the account).
But the nifty thing about a Roth 401(k) (as opposed to Roth IRA) is that the income limits do not apply, so this is never a concern with a Roth 401(k).
You are right. There is nothing preventing Congress from tinkering with tax rates.
In fact, there is nothing preventing Congress from imposing a special tax on IRA or 401(k) distributions (whether they are Roth or Traditional). Maybe they’ll just do it on “fat cats,” but who knows?
Just for the record, under current law, tax brackets are automatically adjusted for inflation each year. No Congressional action is needed. But the taxes on the same nominal income go down.
I agree. It is not obvious to me that people should assume their taxes will go down in retirement if they have saved prudently. It’s the people who are NOT saving for retirement who should expect their taxes (as well as their standard of living) to go down. Unfortunately, this is most of the people in the US.
And, again, if you save in a traditional 401(k) or IRA and do very well for yourself, that RMD when you turn age 70 1/2 could hit you like a bombshell.
Yeah, you do not have any idea what wacky stunt a future Congress could pull. It could make all your current future-planning decisions wrong. So what do you do? Most people just use what information they have to make the best decision under current law.
I don’t know that people would put ALL their money in Roth IRAs (if they could). I mean, you gotta eat and pay rent, right?
The Roth 401(k) limits are much more generous than the Roth IRA limits. And there is no reason you can’t have both. Not all employers who offer 401(k) plans also offer Roth 401(k) plans. The contribution limit on a Roth 401(k) is much more generous than a Roth IRA – $18,500 (plus a $6000 catch-up contribution for those over 50). And if your employer chooses to offer a much more liberal retirement plan than most, you can stuff up to $55,000 a year into your Roth 401(k). (Look up “mega backdoor Roth contribution.”)
It was estimated in 2012 that Mitt Romney had $100 million in his Roth IRA. That didn’t come from investing $5000 a year. And there will be no taxes on it if and when he takes it out.
It’s not quite that simple, though. Knowing for sure which option (traditional or Roth) works out best for you does require a super-deluxe crystal ball. Heck, a tax-deferred plan like a 401(k) might not even be the best choice compared to a regular taxable account when you consider that the capital gains tax rate keeps going down and that your withdrawals from a 401(k) get taxed at the ordinary tax rates, not the capital gains rates.
You do your best and don’t beat yourself up if, in hindsight, you didn’t make the bestest choice.
I’m not assuming anything, oh wise condescending master, just seeking clarification.
This is correct. For the record, employer does match contributions.
Still unsure about:
[ul]
[li]Wise to convert existing 401k to Roth 401k when retiring in 5 years?[/li][li]If yes, how much, percentage-wise?[/li][li]Wise to mark all future contributions to Roth 401k?[/li][/ul]
This is a very important point. It is not just the contributions that a Roth IRA/401k gives you back tax free. It is all of the earnings. Of course earnings are not guaranteed but that applies to the traditional as well.
Roth conversions add to your taxable income, so a large lump sum conversion at retirement can be bad.
In my case, I found that I had enough regular savings so that we did not need to rely on 401k & IRA money before age 70. As a result, I
Converted a portion of my non-Roth account each year until age 70. The exact amount varied, but ‘filled out’ my tax bracket.
Contributed the maximum allowed to my Roth account each year that either my or my wife’s income allowed. (There are income limits regarding Roth accounts, so make sure you qualify. Conversions have no limits)
My Roth goals were to get as much into the Roth account as I could and spend it last (longer growth) or leave it to the kids (who will get it tax free).