- Households paying little or no income tax in working years should select a Roth retirement account over a conventional one.
- The gain from the exemption on tax or deduction from a contribution to a conventional retirement account during working years is negligible for these taxpayers.
- The potential reduction in tax during retirement from use of Roth is huge and from several sources. The Roth distribution is not taxed. Substantial Roth distributions lower marginal and average tax rates. The Roth distribution reduces Social Security benefits subject to tax. The Roth is not subject to a required minimum distribution, which improves tax planning.
- The choice between Roth and conventional accounts can be a bit harder for higher income taxpayers. These taxpayers may have access to Roth 401(k) plans at work that allocate contributions to a Roth account and employer matches to a conventional account.
- The lack of tax on inherited Roth IRAs allows many beneficiaries to avoid large taxes during peak working years.
- Roth accounts can be used as an emergency fund because contributions can be distributed without penalty or tax.
Over 40 percent of U.S. households pay zero or negative federal income tax. A CNBC article finds this number will increase n 2021 due to the family tax credit. Under the current tax code, there are also a lot of people in the 10 percent tax bracket.
People don’t like paying tax. I certainly get that. However, people who are already paying zero or negative tax due to tax credits should pursue other financial goals in addition to tax reduction.
Many of these people will be asked to choose between a traditional deductible retirement plan or a Roth retirement plan.
People not covered with an employer-based retirement plan can usually choose between a Roth and conventional IRA, although, there is an income limit on eligibility for Roth IRAs. Many firms now offer both conventional 401(k) plans and Roth 401(k) plans.
The traditional deductible IRA reduces income tax during the year the contribution is made while the Roth IRA reduces tax in retirement.
The tax reduction for many working-age people who contribute to a conventional retirement account is small, maybe even negligible.
People with negative income tax due to a refundable credit will get a slightly larger refund if they contribute to a conventional retirement plan. People in the ten percent tax bracket could get a savings of 10 percent of the 401(k) contribution, likely a small number.
The existence of a Roth IRA during retirement will substantially reduce tax obligations in retirement through multiple channels.
- The distribution itself is not subject to tax.
- A large Roth distribution could substantially reduce marginal and average tax rates relative to a large distribution from a conventional retirement account.
- The distribution from a Roth rather than a conventional account often leads to a reduction and maybe even elimination of the taxation of Social Security benefits because Social Security benefits are only taxed above certain AGI thresholds.
- People with Roth accounts are not required to take a required minim distribution (RMD) after age 72. The lack of a RMD requirement extends retirement income and improves tax planning.
Working-age people can reduce their tax obligations many ways. They can take the family tax credit if they have children, they can contribute to a health savings account, or they can buy a house and deduct mortgage interest. Many of these measures are generally not used or not available for older households. For example, people over age 65 are covered by Medicare and generally do not contribute to a health savings account. Most people over 65 have paid off their mortgage and no longer deduct mortgage interest or other housing expenses. Few people over 65 have minor dependent children and can claim the child tax credit.
The decision to take a Roth instead of a conventional account can be a bit harder if you are in the top tax bracket. Many of these households will work at a firm that offers both Roth and conventional 401(k) plan. These taxpayers can send their contribution to the Roth account. Employer matching funds are placed into a conventional plan.
There are other advantages with Roth IRAs.
Roth IRAs can be used as an emergency fund. The IRS allows contributions from Roth IRAs to be withdrawn without penalty or tax because they are fully taxed at the time of the contribution. People should not rely on a Roth as the primary source of funds for an emergency. There is also a limited window to repay funds taken from a Roth prior to retirement. This benefit from the use of Roth accounts is extremely important because as indicated by my paper many people taking distributions from conventional accounts prior to retirement are struggling.
The use of Roth accounts allows recipients of an inherited IRA or 401(k) to avoid a large tax bill. Under current tax law, all IRA funds must be distributed over a 10-year period. Conventional retirement accounts, inherited by someone other than a spouse, are taxed as ordinary income. Roth accounts are untaxed. A person that inherits a conventional retirement account during peak earning years could have larger than anticipated tax bills.
The main message here is don’t let immediate tax avoidance dominate your investment, savings and even tax planning goals. Think long not short term. The narrower message here is use Roth not conventional retirement plans.