Roth IRA and 401k – Errors to Avoid
- Going it Alone: Not working with a CPA who has expertise with the best financial planning software to ensure you are a) Converting the optimal amount each year (which may be zero) for your situation and b) Making the right choice between Roth 401k/IRA vs. traditional contributions each year. Otherwise, you risk significantly overpaying the IRS over your lifetime.
- Assuming Roth 401k and Roth Conversions would not add value due to lower income in retirement: Lower income typically means a lower tax rate, but there are “Tax Levers” that can raise your true marginal tax rate, as discussed in the videos below. In one of the examples, someone who might think they will have a 12% marginal tax rate in retirement could end up with a 55.5% true marginal tax rate. Future after-tax Net Worth can be significantly increased with a customized, fiduciary-level analysis that includes potential tax levers.
- Paying the tax from your IRA: You do not want to reduce the IRA or Roth balance and miss out on Tax-Deferred / Tax-Free Growth. If you do not have enough liquid assets outside of retirement accounts to cover the tax on the conversion, expert analysis with scenario comparison is even more important.
Benefits of a Roth Account
- Maximize your Retirement Savings Efforts. You want to maximize your hard-earned savings to your retirement accounts, and for some, that means contributing to a Roth 401k and/or Roth IRA rather than a Traditional 401k-IRA. Applying careful analysis and making the right choice each year to achieve tax-efficiency can significantly reduce your lifetime tax bill total.
- Tax diversification. If the vast majority of your retirement savings is in traditional, non-Roth accounts, re-labeling (converting) some of that as Roth IRA assets can make it easier to pay for big-ticket expenses, long-term care, education for heirs, etc. Pulling extra money beyond your required minimum distribution (RMD) from a traditional account will increase your taxable income, and Roth Conversions add more tax-flexibility for your distributions.
- No tax headache for heirs. Most non-spouse beneficiaries must empty an inherited IRA within 10 years, which could mean large tax bills for them. With a Roth IRA, they still are subject to the 10-year window, but the distribution is tax-free and tax-free growth will continue for them during those 10 years.
- Hedge against rising tax rates. Tax rates are near historic lows, and the federal deficit is at historic highs, so most people think rates will go up. Future tax rate changes are not 100% predictable, but they are a lot more predictable than investments. Even if your tax rate remained flat or dipped slightly during retirement, Roth Conversions can still make sense.
Roth Conversion Analysis Basics
A Roth IRA is an individual retirement account (IRA) that allows tax-free growth and withdrawals, provided certain conditions are satisfied. Also, the original owner is not subject to Required Minimum Distributions (RMDs), as with Traditional IRAs, 401Ks, and other tax-deferred accounts.
A Roth account can be funded from a number of sources including:
- Regular contributions (these have annual limits)
- Spousal IRA contributions
- Roth Conversions (or Roth Relabeling) from Traditional IRAs, 401Ks, SEP IRAs, SIMPLE IRAs, 403Bs, 457s, etc
- There’s no annual limit on conversions, but converting less or more than the optimal amount each year increases your lifetime tax liability.
- Rollover of Roth 401k and After-Tax Contributions
What is the Break-Even on a Roth Conversion?
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