Tip number 3: Most households use traditional retirement accounts instead of Roth accounts. The Tax Policy Center reports around 23% of taxpayers have a traditional IRA compared to around 12% of taxpayers with a Roth IRA. According to CNBC, in 2016 around 70 percent of firms offered a Roth 401(k), but only 18% of workers used the Roth 401(k) option.
More people should choose a Roth retirement plan over a traditional one. People should use Roth accounts in the following circumstances.
- Workers at firms not offering a retirement plan with a marginal tax rate less than 25% should use a Roth IRA instead of a deductible IRA.
- Workers at firms offering both a traditional and Roth 401(k) should choose the Roth 401(k) if their marginal tax rate is less than 25%.
- Workers with marginal tax rates less than 25% at firms with 401(k) plans without employee matching contributions should select a Roth IRA or Roth 401(k) over a traditional 401(k) plan.
- Workers who maximize receipt of employer matching contributions should place additional contributions in a Roth IRA.
- Spouses of workers with family AGI below the contribution limit for Roth contributions should contribute to a Roth IRA, if eligible.
Comments:
- Gains from 401(k) contributions are relatively small when employers don’t provide a matching contribution and a worker’s marginal tax rate is low.
- Workers with Roth accounts are less likely to withdraw and spend all funds prior to retirement than workers with traditional accounts because they can access the amount contributed without penalty or tax prior to age 59 ½.
- The tax saving from Roth disbursements in retirement are high both because disbursements after age 59 ½ are not taxed and the Roth disbursement does not increase the amount of Social Security subject to tax.
- Workers at a firm that do not match employee contributions, around 49 percent of employers, should contribute to a Roth IRA instead of a 401(k) plan unless the worker has a high marginal tax rate.
- One effective contribution strategy is to take full advantage of the employer match and contribute all additional funds to a Roth IRA. 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.
- Most new employees at firms with a vesting requirement, a rule delaying full ownership of 401(k) matches, should contribute to a Roth IRA instead of a 401(k) plan.
- Stay-home spouses of workers with income should choose a Roth IRA over a traditional one if they are eligible. In 2021, a single filer with MAGI less than $140,000 and a married joint return filer with MAGI less than $206,000 cannot contribute to a Roth IRA. Workers with income above these contribution limits should contribute to a Roth IRA. Other workers should use a backdoor IRA.
Readers should remember to open their Roth IRA early in life as explained in financial tip number one.