Tax Efficiency Today and Tomorrow Drive the Decision

For retirees and pre-retirees, a strategic approach to balancing traditional retirement savings vehicles with a Roth account is growing in importance. Taxes and tax brackets will likely be higher in the future, so getting a tax break at that time with a Roth account may be a better option for many retirees.

But calculating the benefits of balancing a Roth account with traditional retirement accounts is not a simple matter. It depends on many factors, the most important of which is your tax bracket.

The question is: Do you want to pay taxes on your income now or in the future? It may be tempting to say you don’t want to pay taxes at all, but the reality is, you’re going to pay taxes. Minimizing taxes through careful management of retirement savings is the best option.

Why is This Important?

In retirement, it’s a good idea to have a pool of money to draw from that is not 100% taxable. Traditional 401(k) plans and IRAs are taxable upon distribution. But Roth accounts are funded with after-tax money up front, meaning you pay current taxes on the money you put into them. Then the distributions are tax-free when you retire.

If you’re in a lower tax bracket now (12%), you may be better off taking your tax savings down the road rather than today. That would argue for shifting some of your retirement savings to a Roth account, which would require that you pay taxes on the funds today in exchange for taking tax-free distributions during retirement.

An example of where the Roth question becomes relevant would be a couple who is married and filing taxes jointly, with income from $81,051 to $172,750, which puts them in the 22% tax bracket. This is an area where several questions arise that require careful analysis and perhaps, a crystal ball. You must consider what is likely to happen legislatively with tax rates. If you’re getting a tax break today, you know the rate you’re applying it against. If you’re going to get a tax break five or 10 years from now, the tax rate you’ll be at is anyone’s guess. And the higher your income, the bigger the question mark.

For income above $172,750, it would likely make more sense to keep your retirement savings in traditional vehicles, so you qualify for the tax break today.

(Higher income earners are not allowed to open Roth accounts, except through their 401(k) plans if the plans have a Roth option written into them.)

Tax Efficiency is Key

We manage our clients’ investments from the perspective of being as tax efficient as possible, both now and in the future. For example, in some cases we’ve looked at a clients’ tax return and seen that the person has had a business loss. They may also have a significant amount of money saved in a traditional 401(k) plan. Say the business loss is $50,000. By shifting $50,000 from the 401(k) to a Roth, that amount becomes immediately taxable income, offsetting the business loss today and providing tax-free income down the road during retirement.

This is what we mean by a “strategic approach” to balancing traditional retirement savings vehicles with a Roth account.

For taxpayers who are within five to seven years of retirement, these questions are immediate. But younger taxpayers should be aware of their options, as well, particularly if they anticipate major life changes in the future, such as a large inheritance. Additionally, at age 72 taxpayers must take required minimum distributions (RMDs) from retirement accounts. Looking at what your RMDs will be, it may make sense to convert some of your savings to a Roth at today’s lower tax brackets before age 72.

For most taxpayers, the key questions are:

  • Are you maximizing use of the lower tax brackets that are available to you?
  • Does conversion make sense?

If you would like to start a discussion about the potential benefits of a Roth conversion for your retirement savings, contact your Adams Brown wealth consultant.