It’s tax season! Most investors hate taxes, but I enjoy the challenge of minimizing taxes over the long term. Wise tax planning is an essential element in smart investing. There are situations where a long-term tax strategy may save you money, even though it requires paying more taxes in the short term. Consider the long-term tax benefits of Roth 401(k)s and Roth IRAs.
Traditional 401(k)s became available in 1978 as a way to save for retirement. Offered by employers, the amount an employee contributes to their account is considered “pre-tax,” and it is deducted from their taxable income. The retirement account is “tax-deferred” until the money is withdrawn during retirement. Employers often contribute a portion of the employee’s contributions (called a “match”), which is an added benefit. Withdrawals are allowed without penalties after age 59 ½, and they are required to begin (termed Required Minimum Distributions, or RMDs) after age 73. The RMD age is increasing to 75 for persons turning 74 after Dec. 31 2032. All withdrawals are taxed as income in the year of the withdrawal.
So, what’s the problem? For most American workers, traditional 401(k)s work great. They contribute to their 401(k) each year on a pre-tax basis, they take withdrawals during retirement to cover their living expenses, and they are taxed on the withdrawals. Income during retirement is not excessive, and the taxes are not onerous.
The problem is that some Americans have saved the maximum allowed by law each year during their careers, and their 401(k) accounts have become large. Many workers now have 401(k)s over $1 million. They are nearing retirement (or recently retired), and they are realizing the impending taxes on the RMDs are going to cause what has been termed a “tax bomb” for the rest of their life.
Let’s assume someone is retiring in 2024 at age 65 with a $1 million 401(k), which they plan to roll into a traditional IRA. They were born in 1959 and must start RMDs at age 75. If we assume their traditional IRA account will grow by 7.2% a year, it will grow to $2 million by age 75. (That’s the “Rule of 72” which states if an account grows at 7.2% a year, it will double in value in 10 years). At age 75 their first RMD will be approximately 3.7%, or $74,000 (for their $2 million traditional IRA). It is fully taxable as income. The RMD percentage increases each year, to roughly 6.3% at age 85 and 11.2% at age 95.
Retirees receive Social Security benefits, and for high income-earners, 85% is federally taxable. Many retirees also have defined benefit pensions and income from interest, dividends, and other investments. This person could have taxable income of $200,000, placing them in the 32% marginal tax bracket (based on 2024 tax brackets). Without the RMD they would be in the 24% tax bracket.
To add to the problem, Medicare surcharges for high income earners were added in 2007, so high income earners can pay much higher Medicare premiums (called IRMAA) each year. As additional bad news, the SECURE Act, passed in December 2019, eliminated the “stretch” previously available to non-spouse beneficiaries, so traditional IRAs must now be withdrawn within 10 years if your children or grandchildren inherit your traditional IRA. The full amount is taxable to the beneficiary.
Often, persons with large traditional 401(k)s or IRAs discover they do not need the RMD for living expenses during retirement, and they would like to avoid withdrawing from their traditional IRA. In addition, leaving a retirement account to children or grandchildren tax-free would be preferred. What’s the solution?
The tax-free Roth 401(k) or Roth IRA Roth IRAs became available in 1998, and most employers began offering Roth 401(k)s during the past 10 years. Contributing to a Roth 401(k) is not a pre-tax contribution, so there is not a short-term tax benefit. Instead, there are significant long-term tax benefits. This is why I consider contributing to a traditional 401(k) a short-term tax strategy, but contributing to a Roth 401(k) a long-term tax strategy.
Typically, the investment choices offered by an employer in a Roth 401(k) are identical to those in the traditional 401(k), so the Roth 401(k) will grow and compound just as quickly during your working years. The enormous difference is that the account is growing tax-free, and when you take withdrawals, they will be tax-free. (A qualifier: This is under today’s tax laws. Currently there are no indications that Congress will decide to penalize Roth 401(k)s or Roth IRAs. After all, you are paying taxes each year on the money you contribute. If Congress changes the rules, they would likely “grandfather” old account balances, and make changes for new accounts going forward).
If you are one of the folks who has been super responsible, and you have accrued a large traditional 401(k), what can you do? One solution is to stop contributing to a traditional 401(k) immediately and start contributing to a Roth 401(k). Another strategy is to start doing Roth conversions to gradually move money from your traditional 401(k) to a Roth 401(k) or Roth IRA. Many employers allow conversions while you are still working, and some allow for withdrawals so you can convert to a Roth IRA outside of their plan. Talk with your employer’s retirement plan administrator.
The “tax bomb” mentioned earlier is most apparent for large, traditional 401(k)s and IRAs. However, Roth conversions can also work well for much smaller amounts. Let’s assume your traditional 401(k) (or IRA) is $200,000, and you are 15 years from retirement. With continued contributions, matches from your employer, and growth, it will likely be over $500,000 when you retire. You may decide you want to convert $25,000, $50,000 or $100,000 a year. I have written several articles on Roth conversions, and they can be found at donnaskeelscygan.com under the Articles heading. The amount you convert will be added to your taxable income in the year of your conversion.
If you expect to have a low-income year, use it as an opportunity for a Roth conversion. If you are planning to retire soon, but you will have a delay before starting Social Security benefits or before being required to take RMDs, this may be an opportune time for a Roth conversion. Roth conversions can be spread over many years. Accounting for IRMAA (Medicare surcharges) begins two years before starting Medicare at age 65, so this also needs to be considered. You can estimate what the taxes will be for converting different amounts using tax software such as TurboTax®, or your tax preparer can provide you with estimates.
If you bequeath a Roth IRA to a child or grandchild (a non-spouse beneficiary), they will have to withdraw the money within 10 years (just like a traditional IRA). However, the withdrawals from an inherited Roth IRA are tax-free, rather than fully taxable from a traditional IRA. Another benefit is that Roth IRAs do not require RMDs, so the money can remain in the account for a longer period, growing tax-free.
A Roth conversion is an example of a long-term tax strategy that provides multiple long-term benefits. It can save you money on future taxes and reduce IRMAA payments during retirement, and it can save your beneficiaries taxes if they inherit your Roth IRA.
Thanks for reading! To receive my monthly newsletter (including instructions for creating a Master Finance and Estate Planning binder for your loved ones, called “Organized and Ready” please sign up here.
Go to my website www.donnaskeelscygan.com, and read past articles here.
Donna Skeels Cygan, CFP®, MBA, is the author of The Joy of Financial Security. She owned a fee-only financial planning firm for over 20 years and is now writing a new book that will be published in 2025.