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For most of their working lives, savers are taught to put money into a pretax 401(k) and delay taxes for as long as possible. But somewhere in your 50s or early 60s, a different question deserves serious consideration: Is it time to stop deferring taxes and start contributing to a Roth instead?
Gary Logan
Wes Shannon
This is a difficult strategy to execute. Many clients in their 50s and early 60s come in with large 401(k) balances that have been in the traditional pretax accounts. They ask me “should we change our contributions from pretax to after-tax Roth contributions?”
The simple answer is very easy to give and yet very hard to practice. (I know because I am practicing it and I feel the pain.) Simple answer: Yes, change all future contributions to a Roth. Pay the taxes now while you have a job and then you won’t have to pay any taxes when you don’t have a job in retirement.
The problem about this strategy is that by the time we are in our 50s and 60s we are making more money than we ever have and are in the highest tax brackets of our lives. If you are making $200,000 and you are contributing $30,000 per year into your 401(k) pretax, your income taxes are about $29,798.
When you change the $30,000 contribution to a Roth contribution your income taxes are about $36,998. That’s an increase of $7,200 in taxes. If you are paid twice a month that is a $300 per paycheck reduction which comes directly from disposable spending. So, putting it into a Roth can reduce your take-home paycheck by $600 or more per month. That’s a big pill to swallow. It will be even more painful if you are making $400k or $500k per year.
Let me tell you about the benefits that come with this pain. In retirement, all of the pretax accounts have a future tax lien.
- Every dime withdrawn from the 401(k)/IRA accounts are taxed as ordinary income. There are no breaks for capital gains.
- Each withdrawal increases the premium of Medicare. Medicare premiums are based upon taxable income and rapidly increase up to $628.90 per person for part B. Income from Roth accounts is excluded from Medicare premium calculations.
- If you retire before age 65 and must buy individual health insurance before you are eligible for Medicare, this taxable income will reduce or wipe out any government subsidies you might receive to offset these costs. The subsidies were very important to many early retirees and now that they are gone many people are paying $1,000 or more per month for health insurance.
- A major strategy for reducing income of wealthy Americans is to use margin accounts for income needs to avoid taxes. Traditional pretax IRAs and 401(k)s are prohibited by law to be used for margin accounts. Making them much more limiting to financial strategies.
- Pretax 401(k)s and IRAs have no favorable “Step-up” in basis at death and therefore the entire balance is taxable to heirs, and this limits the uses for trusts. A Roth account passes tax free to the heirs.
- Pretax accounts are subject to Required Minimum Distributions at age 73 or 75 and Roth accounts are not.
- Prior to age 70½ any charitable deductions from a pretax account are first considered earnings and then deductible subject to charitable deduction rules on the Schedule A form of the 1040. However, a Roth withdrawal is tax free, and the charitable deduction made from that income is deductible per the same rules of Schedule A.
The final argument I can make for making Roth contributions versus traditional pretax contributions is that many of my retired clients who have large pretax balances in 401(k) complain that it is more cumbersome and limiting having all of that money not taxed yet. It just doesn’t feel good.
For this topic and any others, I have written about. Please do not go out and change things based on this article. Have a discussion with a Certified Financial Planning™ professional about your unique situation. At age 50 it is my sincere advice you start working with a CFP® registered adviser who is a fiduciary to plan for a comfortable retirement. Also, having a good financial plan includes knowing a plan for any contingencies that may arise. Remember only about half of Americans get to set their retirement date. The other half have it forced upon them.
Wes Shannon CFP® is a Certified Financial Planning Professional for Brazos Wealth Advisors in Fort Worth.