One of the benefits of reaching 50 is that you get to join AARP. No, I’m not talking about the endless promos you will then begin to receive for dubious insurance, but their magazine and Bulletin, which offer some of the most sensible consumer financial and health advice around. Even if you’re not over 50, it’s worth taking a look at the September Bulletin’s Retirement Guide, which offers an excellent primer on most of the issues. I do have a few comments on their Step 4: Avoid a Nasty Tax Surprise.
It’s a pretty good discussion of the benefits of choosing a Roth or Roth 401k over contributing to a Traditional IRA or a regular 401k. I heartily agree that retirees can find themselves in quite a predicament when they discover that their required minimum distributions (RMD) from the regular 401k or Trad IRA don’t come free—you’re going to pay ordinary income tax on that, and the RMD even has the possibility to kick you up into a higher tax bracket. So that withdrawal is definitely not going to be all spendable income, ouch.
Honestly, I’ve only recommended a client favor contributing to a Trad IRA once this year. In nearly every other circumstance, the better choice is a Roth (and Roth 401k, if your company offers it). Ask yourself:
- Is your income over $60K (single) or $95K (couple)? You’re probably not going to get the deduction anyway. You can contribute to a Roth without phase-out until $114K (single) or $181K (couple). (Regular 401k limits apply to Roth 401ks.)
- Do you think taxes are going down? Most people, according to the article, stay in the same tax bracket when they retire. But it’s probably a safe bet that taxes will be higher in 10, 20, or 30 years so you’ll be paying more on that Trad IRA/401k, plus being taxed fully on increases produced by the investment.
- Does the deduction really help that much? Here, probably the answer is yes in the 401k and no for the Trad IRA. So split it up.
- Could you withdraw money in such a way that in at least some years your taxable income will be low enough so that you won’t pay tax on your Social Security benefits? This is a pretty complex question, so you probably need to give me a call to work through that possibility.
- Any chance you won’t need all your possible income at 70, or maybe at all? With no RMD, you can leave that money invested to grow longer, or leave it to your heirs. Or take it all out at once if you need to pay for long-term care, without incurring more income taxes.
Although the article suggests that you should be at least ten years from retirement to select a Roth, I’m not so sure. Some of these reasons make a Roth desirable even for people much closer to retirement, and in the case of some earners, worthwhile because of the income eligibility limits on the Trad IRA. If you didn’t save from your very first job, and are trying to power-save now, a Roth might still be the right answer.
The old concept of the three legged retirement stool is one I love: no matter a little shortfall or instability in one area, the whole can provide a steady seat.
- Regular taxable investments—at least right now, tax savvy allocation can produce taxation at the capital gains rate rather than at the usually higher ordinary income rate
- Pensions, Social Security, and other guaranteed income, so you have a solid floor.
- Retirement funds—nice if you can manipulate them so that they’re all tax-free coming out (pay attention, those not yet old enough to join AARP). Older workers—don’t beat yourself up! Roths have only been available since 1997.
No, you’re probably not going to be able to dodge the tax man entirely, but paying attention to tax requirements and thoughtful asset location can loosen his hoary grip.