The Roth IRA is certainly not a new concept, but it has seen an increase in popularity over the years due to its promotion as “tax free” money in retirement.
Is this money really “tax free” though?
A more accurate depiction of the funds in a Roth account may be to say “taxed first” rather than “tax free.”
This seemingly small distinction can make a big difference over time, especially if any reasonable amount of compound interest is involved.
Here’s what that means:
When you contribute, defer, or transfer money to a Roth account, you’re not getting any tax savings today. When you contribute, defer, or transfer money to a pre-tax account, like a 401(k) or Traditional IRA, you may be able to exclude that amount from your income for federal income tax purposes until the funds are withdrawn. Just be sure to check your eligibility with your tax preparer, because there are some limitations.
For example, if you make $100,000 and defer $6,500 of that income into an eligible pre-tax retirement account, at the end of the year, you’re only paying federal income tax on $93,500. If you instead contribute that $6,500 to a Roth IRA, at the end of the year you’re going to be paying federal income tax on the whole $100,000 that you earned. More taxable income generally means more money to Uncle Sam and less in your pocket. (These examples are for illustration purposes only, and do not take into account any other deductions you may have against your taxable income.)
Why is everyone enamored by the Roth IRA then?
When you have money in a Roth IRA, the account has been open for at least five years, and your age is 59.5 or older, distributions can be taken without having to pay any additional tax. Some people might say “tax free,” but the reality is, you already paid the tax on those funds when you initially contributed to the Roth IRA, as you can see in the simplified example above.
To figure out which is the better option for you, remember a basic tenet of tax planning: Pay the lowest possible (legal) amount of tax over the planning horizon.
I say planning horizon, instead of lifetime, because some people are planning for multiple generations. Think about your parents asking how they can transfer money to their grandchildren without paying too much in taxes.
As a starting point, if you’re in a high tax bracket now, absent a very good special situation, it’s tough to make an argument for aggressively putting money into Roth accounts. This is because most people are going to have varying exposure to high tax rates during the course of their lives. It is better to wait until your income and corresponding federal income tax bracket are lower to consider Roth accounts.
That being said, Roth accounts can be an extremely valuable tool for the right person, in the right situation, at the right time. Particularly in light of recent changes to tax law in the SECURE Act and more recently in SECURE 2.0.
The more interesting opportunities arise when you are subject to an abnormally low tax rate due to a special and temporary situation. In these instances, Roth accounts should be explored prior to the potential opportunity being lost.
The big takeaway is simply to think about what type of accounts you’re directing your savings into, and why. This thought process should be a continuous and dynamic process you and your advisors evaluate and adapt, at least annually.
The current tax brackets are scheduled to increase effective January 1, 2026. Plan on talking with your Wealth Advisor about any potential tax-savings opportunities well in advance of the change. Our financial planning software can model an endless number of scenarios, provide you with helpful insights to consider and aid in decision making processes. We are always available to assist in determining what may be the appropriate scenario for your personal financial situation.