Don’t Over-Roth Your Retirement

Roth accounts are very popular (with good reason), but can there be too much of a good thing?

Tax now or later?

When saving for retirement, most taxpayers use some form of tax-deferred savings account. The term “tax-deferred” means that these accounts grow tax free and usually have some sort of tax savings when you contribute or withdraw. There are many different types of these accounts, but you probably know them as TSP, 401k, 403b, IRAs, SEP-IRA, Solo 401k, and so on. You also are probably familiar with their Roth equivalents (if applicable).

It can be confusing when faced with the high number of retirement account options. However, these tax-deferred accounts can be boiled down into two main types: Pre-tax “traditional” accounts and after-tax “Roth” accounts.

Pre-tax vs After-tax (Roth) accounts

Before I continue, it’s important to understand the difference between these Pre-tax and Roth accounts. Here is a gross oversimplification.

Pre-tax accounts: Tax free now, pay taxes later. You may know these as traditional IRA, 401k, 403b, or similar. Simply, your contributions are made tax free, all growth is tax free, and normal income tax is levied on qualified distributions (usually when you reach age 59 and a half).

After-tax (Roth) accounts: Pay taxes now, tax free later. These are Roth IRA, Roth 401k, Roth 403b, or similar. Simply, you pay income tax on your contributions, all growth is tax free, and all qualified distributions are tax free (again, usually when you reach age 59 and a half).

For more detailed information, here is a more detailed overview from Vanguard.

Which is better?

With tax-deferred accounts, basically you’re forced to decide to pay taxes now or pay taxes later. Either way it’s a great deal, but which is the better choice? As always, the answer depends on your personal circumstances and goals. Let’s look at why you might choose one over the other.

First, why Roth accounts are a good thing

There are a handful of reasons why Roth accounts are a great idea, but here are a few of the most common.

Take advantage of low earning years. Whenever a taxpayer experiences a “low paying year,” it is a good idea to use Roth accounts to fund retirement savings. Young workers are typically in this category, but those on sabbatical or short term unemployment may also find an opportunity to contribute or convert to Roth accounts. A great rule of thumb: If you’re in the 10-15% marginal tax bracket, you should probably consider using Roth accounts to pay taxes now while your marginal tax rate is lower.

Know your future tax bill. No one can predict the future. If you’re uneasy about the future of income tax rates or simply want to eliminate the burden of tax liability in the future, Roth accounts can help. For those in the 22-28% marginal tax brackets, this is a typical justification to use Roth accounts.

Easy planning. Again, no one can predict the future. Planning for retirement income can be difficult when trying to predict tax rates 20-30 years into the future. These things can be estimated but it’s never easy. Instead, by using Roth accounts you can safely estimate a 0% tax burden for these funds and plan more accurately. This is another typical reason to use Roth accounts for those in the 22-28% marginal tax brackets.

Taxes are “on sale”. Thanks to the Tax Cuts and Jobs Act signed into law in 2018, tax brackets are currently lower compared to recent history. For example, the previous 25% bracket is now 22% and the 28% bracket was lowered to 24%. Along with other lower brackets combined with increased standard deductions, the tax burden for most every taxpaying American is currently lower than normal. These lower brackets remain in effect through 2025 and are expected to expire in 2026 pending any further legislation. For taxpayers who expect to stay in the same tax brackets in retirement, they can take advantage of current lower tax rates with Roth accounts.

When traditional, pre-tax accounts are a good idea.

The answer to this is much more simple: You should avoid Roth accounts when you need to reduce your current taxable income. If you’re in the 32% tax bracket or your income is cresting above the next marginal tax bracket, contributing to your pre-tax retirement 401k, 403b, or traditional IRA accounts is probably a good idea.

Can you over-Roth your accounts?

OK, as we’ve seen, Roth accounts are very beneficial to most taxpayers. In fact, the popularity of Roth accounts has grown steadily ever since they were introduced in 1998. If you’re keen on Roth accounts, then you’ll have tax free income to look forward to in retirement. Well done.

However, if you’re someone hoping to have all of your retirement savings in Roth accounts, you might be over-doing it. If this is you, then I urge you to consider one very important point:

Tax brackets exist in retirement, too.

The debate between Roth vs pre-tax accounts usually revolve around current tax brackets. That is, trying to guess if you paying lower or higher rates now than you expect to pay in retirement. This is wise advice, but often we fail to think clearly on how tax brackets work in retirement. The fact is, they work for retirees the same as savers. That is, the less income you receive, the lower tax rate you pay.

Why this matters

This point matters because there is a tax break we all receive. Since the income tax system is marginal, we are all taxed a very low 10% on the first dollars we make each year. Yes, even retirees! If you’re a retiree and only receiving Roth distributions, you’re currently missing out on this low tax opportunity. You might argue that paying no tax on these distributions is better than paying 10%, but remember you likely paid 15-25% of your contributions for this benefit. Paying 15-25% on contributions to avoid paying 10% in retirement doesn’t make much sense.

This window isn’t small, either. The government gives you a range of income taxed at very low rates. They also give you multiple deductions to reduce your taxable income. For instance, a retired married couple in 2024 can earn up to $123,500 and stay in the 12% tax bracket ($94,300 upper limit of the 12% bracket plus the standard deduction of $29,200). It would be a shame if this couple spent years in the 25% tax bracket contributing/converting to Roth accounts only to avoid a 12% tax in retirement.

Admittedly, in order to “fill up” the 10-12% retirement tax brackets with traditional accounts would take quite a bit of planning. However, remember these brackets are marginal. That means even if you do go over a little, the next tax rate is only taxed on those dollars that creep into the next bracket. Remember, this is where a financial planner can help.

Mind the Social Security threshold

If you’re sold on the idea of filling up lower taxes brackets in retirement, you should also consider Social Security tax thresholds. The same ideas apply, but this threshold is much lower.

This part can get a little complicated, but it’s important.

For lower earning retirees, social security benefits can be received tax free. However, there are two main income points that trigger taxation on these benefits.

For instance, in 2024, married individuals can earn up to $32,000 in taxable income before any of their social security income is taxed. For married couples earning between $32,000 and $44,000, up 50% of Social security benefits may be taxed. Above $44,000, 85% of social security benefits may be taxed.

*When calculating this threshold, half of your social security benefits are included along with non-taxable income such as interest from municipal bonds. Questions? Reach out directly to learn more.

You may react to this and say, “but Roth accounts aren’t included in taxable income.” You’re right! If you had all Roth accounts, you would have $0 taxable income and wouldn’t be taxed on Social Security.

But again, you did pay taxes on it

You paid a price for this tax free benefit.

Calculating the taxes you will pay in retirement is really important when deciding which retirement account to use. After all, celebrating saving 10% taxes in retirement when you paid 22-25% during your working years is hardly a win. It may feel good, but you left a lot of money on the table.

This takes some planning

I breezed over some very complicated planning points there. Also, there are many other items and deductions that affect your AGI that you should consider. Further, there are ways to reduce taxable income in retirement should doing so make sense. Medical expenses and charitable gifts are two main ways to do so. There is a lot to think about.

The important point is, if you’re pouring everything into Roth accounts, there is wisdom in contributing something to a pre-tax account. Remember, tax brackets exist today and will likely exist when it’s time to withdraw from your accounts. Tax savings are everywhere, tomorrow and today. Make sure to plan accordingly.