A Modified Roth IRA


Many people, for a wide variety of reasons, are failing to save enough for retirement. The proposal presented and evaluated here seeks to expand retirement savings by replacing 401(k) plans with a modified Roth IRA.  

The modified Roth IRA maintains key features of current Roth IRAs but adds additional sources of contributions in the form of employer matching funds and contributions for low-income households from the government.  The modified Roth IRA creates incentives for young people and people with debt to start saving for retirement early in their career and prevents people from disbursing their entire retirement accounts prior to retirement.  The tax incentives for contributions to the modified Roth could increase workforce participation.  The introduction of the modified Roth is more equitable than the current system, which favors workers at firms with generous but expensive 401(k) plans.

Description of the modified Roth IRA:

  • The basic rules governing worker contributions to the modified Roth are identical to rules governing current Roth IRAs. Contributions are fully taxed during the year the contribution is made.  Contributions as with current Roth rules.  Contributions cannot exceed wage income of the household.  All employee contributions to the modified Roth IRAs can be withdrawn without tax or penalty at any time.  All disbursements from the modified Roth after age 59 ½ are untaxed.
  • The modified Roth allows for additional contributions from employers, from people hiring an independent contractor, and from the government.   The rule allowing non-taxed compensation to independent contractors will allow more people to work independently and save for retirement.  The government contributions are only available for workers from low-income households and will not exceed $10,000 over the lifetime of the workers.
  • Disbursements from investment returns, government contributions and employer contributions would not be allowed until age 59 ½.  
  • The maximum allowable employee contribution to the modified Roth account is $10,000 per year, indexed for inflation.

Advantages of the modified Roth account:

  • There are strong incentives for young people to open a Roth account and start saving as soon as they enter the workforce.   The modified Roth account expands gains from saving at a young age because matching contributions would compound for years.
  • People entering the workforce with student debt often delay or forego 401(k) contributions. There is less incentive to delay contributions to a Roth retirement account than a traditional one because contributions can be used for emergencies or for debt reduction without penalty or tax.  The modified Roth maintains this advantage and allows for additional matching contributions, which will compound over time.
  • Many young adults now routinely distribute a substantial portion of their 401(k) savings early in their career often when switching to a new position.   The rules of the modified Roth IRA guarantee that a portion of retirement savings, employer and government contributions cannot be withdrawn until age 59 ½.   This proposal substantially reduces shortfalls in retirement income caused by early distributions. 
  • Many employees work at firms that do not offer 401(k) plan or work at firms that do not match employee contributions.  The modified Roth IRA will provide for some matching funds for workers
  • Independent contractors do not have access to matching funds from people hiring them.  The modified Roth allows for matching contributions for people hired as independent contractors.  The matching contributions for contract employees would be the outcome of a negotiation between the firm and the independent contractor.   
  • Workers at firms without employer contributions could obtain matching contribution.
  • Some current 401(k) plans lock workers into a high-fee 401(k) plan, which leads to a substantial loss in retirement wealth.  The modified Roth account described here allows workers to choose a low-fee investment vehicle from a firm like Fidelity, Schwab, or Vanguard.
  • Unlike the child tax credit, the government contributions to the modified Roth are only available for households with wage income.  The combination of tax-free retirement savings and some matching contributions from employers or the government could induce some people to remain attached to the workforce.
  • Some people will choose to report income they otherwise might have reported because without reported income they will be ineligible to contribute to the modified Roth an ineligible for matching contributions. 

How to pay for the modified Roth IRA:

  • The selection of the modified Roth leads to lower use of 401(k) plans and lower loss of tax revenue from decreased 401(k) usage.
  • Additional tax revenue from the introduction of the modified Roth account could be obtained by reducing allowable contributions to 401(k) plans. 
  • A tax of 1 percent of Roth balance over $2,000,000 would recoup some revenues and would be more equitable than current required minimum distributions.
  • The increased retirement savings induced by the modified Roth IRA could lead to a phased change in the Social Security retirement age from 62 to 63 to reduce the long-term Social Security deficit.
  • Part of the cost the modified Roth could be offset by a reduction in the child tax credit.   The combination of a modified Roth and a smaller child tax credit would remain favorable to low-income households and would expand labor force participation relative to current subsidies.

Concluding Remarks:

Many policy proposals either improve equity and reduce economic growth or worsen equity and increase growth.  The additional subsidies created in the modified Roth proposal are both progressive and pro-growth.   The new subsidies stimulate savings by low-income households, workers without access to the most generous 401(k) plans and new entrants to the workforce with high levels of debt and low levels of liquid assets for emergencies.  The new subsidies, in sharp contrast to some existing subsidies like the child tax credit, stimulate workforce participation, which will lead to higher economic growth.

The case for greater use of Roth retirement accounts

  • Many workers should increase their utilization of Roth retirement accounts. 
  • Young workers should open a Roth account as soon as they enter the workforce.
  • There is very little downside for contributions to Roth accounts by low-income workers because the worker opening the Roth has immediate access to contributed funds without tax or penalty and the tax advantages from contributing to a tax-deductible account are small.
  • There is no reason to choose a traditional retirement account over a Roth if your marginal tax rate is zero and if the employer does not match contributions to a traditional retirement plan.
  • Roth contributions are likely to result in a better outcome than traditional contributions for most workers with a marginal tax rate less than or equal to 22 percent, especially when the employer does not match contributions.
  • Most workers at firms with matching contributions to a traditional plan should divert additional contributions to Roth accounts after maximizing the employer match. 
  • Roth accounts are usually superior to traditional accounts for workers without emergency funds or high debt levels who might tap retirement funds prior to retirement.
  • Households experiencing a decrease in income because they or their spouse temporarily leave the workforce should convert traditional retirement asset to Roth assets when their marginal tax rate is low.
  • People leaving a position can rollover 401(k) assets to an IRA and then convert the traditional IRA to a Roth IRA.
  • Some firms with Roth 401(k) plans allow for in-service rollovers.
  • Retired workers should spend from assets outside their retirement plan and convert traditional retirement assets to Roth assets prior to claiming Social Security and disbursing traditional retirement assets.


One of the most important decisions for workers preparing for retirement involves the choice between use of traditional and Roth retirement accounts.   

Contributions to the traditional retirement accounts are not taxed in the year the contribution is made. Contributions to the Roth IRA are fully taxed in the year of the contribution but are not taxed when disbursed prior to age 59 ½.   Moreover, Roth distributions are not included in AGI and do not increase the amount of Social Security subject to tax.

All funds (both initial contributions and investment returns) inside a deductible IRA or a traditional 401(k) that are withdrawn prior to age 59 ½ are fully taxed and subject to a 10 percent penalty.  By contrast, contributions to a Roth retirement account are fully taxed in the year they are made but disbursements of contributions from the account prior to age 59 ½ are not subject to a penalty or tax.  The tax penalty for early withdrawals from a Roth is only applied to returns on investment.

Many workers overutilize traditional retirement accounts and underutilize Roth accounts.  The tax savings from incremental contributions to a traditional retirement account are often small.  The cost of converting traditional retirement assets to Roth assets is often low. Retirees with a mixture of Roth and traditional retirement assets often have substantially higher after-tax income and are less likely to outlive their retirement assets than people with all retirement assets in a traditional retirement account.

A Roth retirement account should be a key feature of your financial plan. We discuss steps you should take to increase savings though Roth accounts:

Set up a Roth account as soon as you get your first job:

Any person with income reportable to the IRS regardless of age can set up a Roth account.   A teenager can and should establish a Roth. It is possible for a young person doing real work for a family business to establish a Roth, but this type of transaction could be audited by the IRS.

Most teenagers who work don’t think about setting up an IRA but there is basically no downside from Roth contributions by young workers.  The Roth contribution could be disbursed or spent if necessary and only investment income is subject to tax.  The gains if left in the account until age 59 ½ will compound for a long time and will never be taxed.  The mere existence of a Roth IRA in a student’s name does not reduce the ability of a student to qualify for financial assistance for college.   

A working teenage with modest income would never choose a deductible IRA over a Roth because there is no immediate tax savings for a taxpayer that earns less than the standard deduction, $12,400, and disbursements in future years could be subject to tax and penalty.  The teenager is entitled to a standard deduction of earned income plus $300 even if the parents claim the child as a dependent.

Most young adults entering the workforce should choose a Roth IRA over a traditional 401(k) plan or a deductible IRA when the firm does not offer a 401(k) plan with an employer match.

Around one-third of employees at private firms do not have access to a retirement plan and around 49 percent of employers with 401(k) plans do not match employee contributions.

The choice between a Roth retirement account and a traditional retirement account is straight forward when there is no matching contribution.  The after-tax contribution to a conventional IRA or traditional 401(k) plan is the pre-tax contribution minus the immediate tax savings. Workers should make contributions to Roth accounts when their marginal tax rates are low and make contributions to traditional deductible accounts when their marginal tax rate is higher. 

A person filing an individual return making $12,400 or a married couple filing a joint return making $24,800 in 2020 claiming the standard deduction would pay $0 in tax.  These taxpayers could also reduce tax on additional earning by contributing to a health savings account.

The savings from contributing to a deductible IRA would be $0 because the person does not pay any tax. It is basically irrational for this person to contribute to a deductible IRA instead of a Roth IRA because the tax preferences are larger from the Roth and there is no gain in working years from contributing to the deductible IRA.

Interestingly, it is also almost irrational for a person in the 0 percent tax bracket to fail to contribute to a Roth.   The worker has immediate access to his Roth contribution without penalty or tax and only pays penalty and tax on investment returns prior to age 59 ½. 

At higher tax rates the tax deduction from the traditional IRA becomes more valuable.  A taxpayer facing a 12 percent marginal tax rate for the last $6,000 in AGI would have identical working year spending by contributing $6,000 to a conventional IRA or $5,280 contribution to an after-tax Roth account.

When the last $6,000 is taxed at 22 percent the taxpayer can either contribute $6,000 to a pre-tax traditional plan and pay no additional tax or contribute $4,680 to a Roth and pay $1,320 in additional tax.

The potential tax savings from the use of Roth assets both to the taxpayer in retirement and the person who inherits the Roth account can be very large.  Most taxpayers are better off using a Roth instead of a traditional retirement plan if their marginal tax rate is less than 22 percent.

Consider selecting a Roth IRA over a 401(k) plan with matching contributions if you have high levels of debt and/or have not met 401(k) vesting requirements.

Many financial planners argue that all workers at firms with 401(k) plans that match employee contributions should maximize the employer match because the employer match is free money.  My view discussed here is that even when firms match employer contributions new workers with substantial debt should prioritize debt repayment over saving for retirement.

The failure to pay debt on time can lead to a bad credit rating and higher borrowing costs for an entire lifetime.  The contributions in a Roth can be used to avoid this outcome.

Many young adults entering the workforce with substantial debt in the form of student loans do not have funds for an emergency.   As a result, many young adults with traditional retirement plans disburse funds early and incur taxes and penalties.  A person with a Roth account could disburse Roth contributions without penalty and tax.  The retirement account would remain open and hopefully the worker would not touch capital gains.

Often new workers will not receive the employer matching contribution unless they stay at a firm long enough for the contributions to vest.   Many workers will be better off leaving for a better job instead of staying for the employer match. 

Workers who have not met the vesting requirement for employer matches and who are not likely to meet the vesting requirement should invest in a Roth IRA rather than a firm-sponsored retirement plan.

Contribute to a Roth IRA after taking full advantage of matching employer contributions to your 401(k) plan.

Many employers with 401(k) plans match employee contributions.  Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary.  

The employer matching contribution to 401(k) plans is an attractive benefit if you are not drowning in debt, have funds for basic emergencies and will not lose the matching funds or be unable to move to a better job due to a vesting requirement.

Workers can divert additional retirement plan contributions to a Roth IRA once they obtain the entire 401(K) match from their employer.   Direct contributions to Roth IRAs are not allowed for higher income workers, however, higher income workers can contribute to a Roth through a backdoor IRA. 

The strategy of contributing to a 401(k) plan to obtain the full employer match and then diverting additional contributions to a Roth IRA will leave the worker with a mix of traditional and Roth assets in retirement.

Consider contributing to a Roth 401(k) plan instead of a traditional 401(k) plan if one is offered at work.

Roth 401(k) plans became available January 1, 2006. Prior to that date, after-tax or Roth retirement options were only available through IRAs. Seven in ten firms now offer a Roth 401(k) option. However, only around 18 percent of workers contributed after-tax dollars to their 401(k) plan in 2016.

The Roth 401(k) plan has two advantages over a Roth IRA.  First, contribution limits are much higher for 401(k) plans than for IRAs.  Second, employers can match employee contributions to all 401(k) plan including Roth plans but cannot match contributions to IRAs. Note, employer contributions to Roth IRAs are placed into a traditional account and are fully taxed at retirement and are subject to tax and penalty if disbursed prior to age 59 ½.   Go here for a discussion of features and rules governing Roth 401(k) plans.

The decision rule for the choice between contributing to a traditional 401(k) plan or a Roth 401(k) plan depends primarily on the marginal tax rate of the worker, assuming the same level of matching contributions.  Workers should contribute to a Roth when marginal tax rates are low and contribute to a traditional plan when marginal tax rates are high.

The use of a Roth 401(k) plan will result in the worker retiring with a mix of traditional and Roth retirement assets, which substantially reduces taxes and improves financial outcomes in retirement.

Convert traditional retirement assets to Roth assets in years when household income is low:

Tax law allows people to convert traditional 401(k) plans and IRAs to Roth IRAs.  The conversion can occur at any age.  Most conversion of 401(k) assets occur after the employee departs from a firm and transfers 401(K) assets to an IRA.  However, some firms with Roth 401(k) plans allow for in-service conversions for older workers.

The amount converted is treated as ordinary income and the cost of the conversion is the additional tax paid due to the increase in reported income.   

The conversion of traditional retirement assets to Roth assets when the household has a marginal low marginal tax rate is profitable and can substantially reduce the likelihood of a person outliving her retirement resource.  The cost of conversion is zero if the taxpayer is in the 0 percent tax bracket or when the taxpayer earns less than total deductions.

The profitable conversion of traditional to Roth assets could occur when a person leaves the workforce for part of a year.  This commonly occurs when a person returns to school or when a spouse temporarily leaves the workforce.

Profitable Roth conversions can also be implemented early in retirement prior to the retiree disbursing funds from a traditional 401(k) plan or claiming Social Security benefits. The strategy of Roth conversions early in retirement described in this recent article requires the household  use assets outside of her retirement plan to fund current consumption.

Money converted from a traditional IRA or retirement account to a Roth is subject to the five-year rule.  Converted funds that are disbursed before five years from the end of the calendar year of the disbursement are subject to tax and a 10 percent penalty.

Contribute to a backdoor Roth IRA if you have excess cash at the end of a year.

Tax rules establishes limits on household income for allowable direct contributions to Roth IRAs.  Direct Roth IRA contributions are prohibited for single filers with income greater than $140,000 and married joint filers with income greater than $208,000.  (The phase out of direct Roth contributions occurs at $125,000 for single filers and $198,000 for married joint filers)

People with income above these limits can make indirect contributions to Roth IRAs by first contributing to a non-deductible traditional IRA and then immediately convert the funds in the non-deductible IRA to a Roth IRA.  This technique is called a backdoor IRA.

The contributions in the non-deductible IRA are not subject to tax at the time of the conversion because funds in the non-deductible IRA were taxed in the year the contribution was made.  The funds in the newly created Roth IRA are subject to tax and penalty if disbursed prior to five years from December 31 of the year of the conversion even after age 59 ½.   The goal of the five-year rule is to prevent immediate gains from the conversion. 

reconciliation bill recently passed by the House would abolish backdoor IRAs. One rationale for abolishing the backdoor IRA is that it favors the rich.  However, many incomes do not have income levels persistently above the contribution thresholds and not all households making backdoor contributions are wealthy based on a lifetime income concept.  In my view, the proposal to abolish backdoor IRAs is misguided because tax law should encourage additional savings in good years.

 Concluding Thoughts:

People are becoming more aware of the advantages of Roth retirement accounts. Households retiring with a mix of both traditional and Roth assets are much better positioned than household that are dependent on traditional assets.  A recent CNBC article found that many millennials are now recognizing the value of Roth IRAs.  

However, the use of Roth accounts remains counterintuitive to many households. Contributions to Roth accounts and conversion of traditional retirement accounts are more profitable when household income and marginal tax rates are low when it is harder to save for retirement.