The Roth IRA is one of the most powerful vehicles available for wealth accumulation and transfer… and a Roth option is available in many 401(k) plans. We have recently had several discussions in planning meetings involving the comparison between a Traditional 401(k) and the Roth 401(k) option. Although you do not get a current tax deduction for a Roth contribution the assets in your Roth grow tax free, there are no required minimum distributions (RMDs) in the future and neither you nor your beneficiaries will pay tax on future distributions after age 59.5. Every person’s situation is unique so we encourage you to get professional tax advice before proceeding, but understanding certain situations in which to implement the Roth strategy could be helpful in making your decision.
1. Relatively low marginal tax rate
The definition of “relatively low” may be subjective, so for the purpose of this article we will suggest a marginal tax rate of no more than 22% (that’s the 2020 federal tax rate for taxable income up to $171k for Married Filing Jointly). Typically, people find themselves in a lower tax bracket while they are young and move into higher brackets as they progress in their career. This low rate could also apply to many who have retired but have not yet begun to have to take social security income or RMDs from their qualified plan accounts (IRAs and 401(k)s). The assumption is that you would rather be taxed now while the rate is relatively low than wait to pay income tax on traditional 401(k) distributions at a higher rate.
2. Majority of retirement savings are held in traditional 401(k) or IRA accounts
This is not an ideal position to be in when you retire because you will pay ordinary income tax on every dollar that comes out of those accounts. We sometimes recommend that clients split their IRA or 401(k) contributions between the traditional IRA/401(k) and the Roth option if available. Also, converting some of your 401(k) into a Roth might make sense if most of your retirement assets will be taxed upon distribution. There are several factors to consider before converting including current cash on hand, tax rates, and other income sources.
3. Estate Planning – avoid beneficiaries paying tax
Prior to 2020, your beneficiaries could take their RMDs over the course of their lives. This provided good flexibility and spread the taxes out over potentially a very long time. However, the law was changed in 2020 to require your beneficiaries to take a full distribution, and pay the related taxes, over a ten-year period. Particularly for larger IRAs, this income could throw your beneficiaries into higher tax brackets and makes the inherited IRA much less valuable to them than an inherited Roth IRA. The downside is that if you decide to convert part or all of your IRA to a Roth, you must pay income tax in the year of the conversion. However, some are willing to “prepay” that tax for the benefit of their heirs. Another note - unlike you, the heirs must take RMDs from their inherited Roth IRA, but they are still tax-free.
Please give us a call to discuss your specific situation.
Matt and Andrew