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Is It Time to Rethink Roth Contributions?

Updated: 02-11-2024, 09.18 PM

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A Roth IRA offers significant benefits for retirees. As an after-tax account, distributions from Roth IRAs are typically tax-free. This can save you a lot of money in retirement, but at the cost of up-front tax payments while you’re saving. You will spend more to build your portfolio today, but will save money later.

A financial advisor can help you plan and save for retirement. Find a fiduciary advisor today.

For example, say that you’re married and in your late 50s. You and your spouse have a 401(k) with $1.6 million and are building toward a strong retirement. Would you benefit by switching to Roth contributions?

In this case, most households may benefit by sticking with their pre-tax contributions, but the answer will depend on a number of factors. Here’s how to think about it.

As an after-tax account, a Roth IRA doesn’t offer any tax deduction or credit for your contributions up front. The benefit comes in retirement when you can withdraw your money tax-free.

This is the inverse of a tax-deferred retirement account, like a traditional IRA or 401(k). Such accounts provide an income tax deduction on all contributions – up to the annual contribution limits – for the year in which they’re made. Then, in retirement, you pay income taxes on all withdrawals (both returns and principal).

Up-front taxes are the main disadvantage to a Roth IRA. The money you spend on taxes is capital that you could have otherwise invested for long-term, tax-deferred growth. For example, say that you pay an effective tax rate of 20%. With a Roth IRA, you’d have to earn $1.20 for every $1 you save to account for taxes on your contribution. With a 401(k), on the other hand, you can save and invest the full $1.20 in pre-tax earnings.

But there are significant advantages to Roth IRAs. First, and most notably, you can keep all the money you withdraw from this account (provided that you adhere to a few rules). By contrast, all withdrawals from a 401(k) are effectively reduced by your income tax rate.

Second, a Roth IRA is excellent for maximizing growth. The longer this portfolio grows, the more value its tax-free withdrawals will have. Third, Roth withdrawals can help keep your Social Security benefit taxes low since they do not increase your taxable income.

Fourth, and finally, Roth IRAs are not subject to required minimum distributions (RMDs), so you can keep the money invested for as long as you want.

If you’re unsure whether a Roth IRA is a good option for your financial circumstances, consider speaking with a financial advisor.

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