Ain’t no Dollar like a Roth Dollar

I’ve read dozens of articles over the years regarding Pretax IRA or Pretax 401k versus Roth IRA and Roth 401k. Most of those articles describe the differences in tax treatments and some considerations based on your individual income and tax situation, then the ultimate recommendation is generally a non-recommendation. At best, the author suggests doing some of one, then some of the other. Well, I’m taking a firm stance on Roth over Pretax, and I’d like to walk you through the 3 primary considerations why I believe Roth dollars are so dominant.

For simplicity, I will merely refer to “Pretax” and “Roth,” but it applies to both individual IRAs and 401ks. There are specific differences between IRAs and 401ks that I will address in a subsequent blog posting.

First, some definitions:

Pretax: This refers to contributions made before taxes are assessed on your income. You’ll also see this described as “Traditional.” Taxes on this money are deferred.

Tax Deferred: This basically means “not now, but later.” You are deferring the taxation on the money until a later date, typically when you make a distribution.

After-tax: This refers to contributions made after taxes are assessed on your income. Roth contributions are after-tax.

Tax Exempt: This basically means “not now, and not ever.” There are unique exceptions to this, such as premature distribution penalties, but if you follow the rules and the age restrictions, those penalties won’t apply, and distributions will be tax free.

401k: This is your workplace plan. I will refer to 401k, but the same rules apply to 403b plans (retirement plans for public employees) and Thrift Savings Plan (TSP, the retirement plan for Federal Government workers and military). Most plans offer either Pretax/Traditional or Roth 401k options.

IRA: This is your own Individual Retirement Account. There are some income limitations regarding deductibility of Pretax/Traditional IRAs, or direct contribution into Roth IRAs that I’ve previously published.

Required Minimum Distribution (RMD): This is a legally required minimum amount that you must take out of Pretax accounts when you reach a certain age (Currently 73), or that you must take from Pretax accounts if you are a non-spousal beneficiary.

Spousal Beneficiary: When the beneficiary of your 401k or IRA is your spouse. In the event of your passing, your spouse inherits the 401k or IRA as if it was his/hers the entire time and is subject to distribution rates (RMDs) based on his/her age instead of yours.

Non-Spousal Beneficiary: As the name suggests, this is when the beneficiary of your 401k or IRA is not your spouse (child, sibling, anyone else). For married couples, this is typically listed as a contingent beneficiary after the spouse. For single individuals, children or others may be listed as primary beneficiaries. For Non-Spousal Beneficiaries, there are unique distribution rules that require RMDs on any Pretax money, and all funds across all accounts (Pretax or Roth) must be pushed out of the retirement accounts within 10 years (“The 10-Year Rule”).

Now, onto the good stuff!

Point 1: As long as you meet the minimum distribution age, your Roth contributions and the subsequent growth are always tax exempt.

Roth contributions are made with after-tax dollars and are therefore tax exempt moving forward. Additionally, the subsequent growth on that money is also tax exempt. Over several years of compounded growth, the growth on your original contributions often surpasses your original contributions. As long as you are making qualified distributions after age 59.5, all distributions are tax free. Roth 401k contributions are limited to $23,500 this year, plus $7,500 if you are 50+. Roth IRA contributions are limited to $7,000 this year, plus $1,000 if you are 50+.

Logistically, Pretax 401k contributions are made before taxes are assessed in your paycheck. For a Pretax IRA, you make contributions, then deduct them after the fact while filing your taxes, assuming you don’t exceed the income thresholds. In both occasions, the contributions are Pretax, and the subsequent growth on that money is Pretax. This means that when you make distributions in retirement, you owe income taxes on the full amount of the distribution. Pretax 401k contributions are limited to $23,500 this year, plus $7,500 if you are 50+. Pretax IRA contributions are limited to $7,000 this year, plus $1,000 if you are 50+.

While the contribution limits look to be the same, if you think about it, the Roth amounts are effectively higher for you. Why? Because the IRS has a claim on a portion of your Pretax contributions and growth forever. Basically, the IRS has a hand in your pocket for the rest of your life, and for your beneficiary’s life (I’m currently hissing like a cat at the mere thought). You may feel good about the current year’s deduction on the contributions in the Pretax accounts, but the growth is also income-taxed when you take distributions. The best you can do to mitigate the amount of income taxes owed is by severely limiting your distributions in retirement (keeping your income intentionally low, which may be contrary to your retirement plans!), or by donating the Pretax account distributions straight to charity.

Point 2: You can take as much or as little from your Roth account in retirement, and it’s not taxable.

As long as you’ve reached distribution age in retirement, you can take as much out of your Roth accounts as you’d like without tax consideration or consequence.

Further, you can take as little as you’d like out of your Roth accounts, because they are never subject to RMDs!

At age 73 (currently…it’s supposed to go up to 75 at some point over time), you are legally required to make Pretax distributions whether you want them or not. The IRS is basically giving you a deadline to start giving them their pound of flesh out of your Pretax retirement accounts. But not Roth. Roth balances are not subject to RMDs for either you, your Spousal Beneficiary, or your Non-Spousal Beneficiary.

Point 3: Roth is a tax efficient estate planning consideration

I just pointed out that Roth distributions aren’t taxable to you as long as you meet the minimum age, and they aren’t taxable to your beneficiaries. Pretax accounts are income-taxable to you when you take distributions, and to your beneficiaries when they take distributions.

Remember, a Spousal Beneficiary inherits the Pretax or Roth account as if it was his or hers all along. The Pretax balances are subject to RMDs and income taxes while the Roth balances aren’t subject to either.

But Non-Spousal Beneficiaries must abide by the 10-Year Rule, meaning all assets have to be distributed by the end of the year, 10 years after your passing. The 10-Year Rule applies to both Pretax and Roth Accounts.

Those Pretax accounts are subject to RMDs, generally based on the Non-Spousal Beneficiary’s age, and all distributions are income taxed. There’s a bit of strategy here where you have to figure out how to best spread out those distributions over the 10 years without subjecting the beneficiary to unnecessarily high income taxes. This isn’t always preventable, but we certainly try.

Roth accounts are not currently subject to RMDs, and regardless of how much you distribute, it’s not subject to taxes. The best strategy here is to let the account grow and compound over the subsequent 10 years and distribute the entire account on the last possible day for the largest possible tax free distribution to the beneficiary.

Besides varying distribution strategies between those account types, an additional problem is that most Non-Spousal Beneficiaries will inherit their parents’ retirement accounts during the beneficiary’s highest income earning years of their professional lives. I don’t have data in front of me, but I would guess that a majority of Non-Spousal Beneficiaries are between the ages of 45 and 65, which compounds the income taxation on that individual when they inherit Pretax accounts.

Strategy and Recommendations:

Included in the myriad of services and strategies that we pursue on behalf of our clients, the two items below relate directly to our considerations of Pretax or Roth investments:

• Fully exploit tax-efficient Retirement investment strategies
• Provide for tax-efficient passage of assets across generations

As such, we make recommendations that maximize Roth contributions in the following ways:

• Maximizing Roth 401k contributions and Roth Catch-Up Contributions
• When available in a 401k plan, making additional After-Tax Contributions then requesting In-Plan Conversions of that money to your Roth 401k.
• Maximizing direct Roth IRA contributions if income permits
• Using Back-Door Roth IRA Conversions if there are no pre-existing pretax IRA balances.

I hope you found this insightful and certainly reach out with questions!

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Brent Elyea and not necessarily those of Raymond James.

Every investor's situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

Changes in tax laws or regulations may occur at any time and could substantially impact your situation. While familiar with the tax provisions of the issues presented herein, Raymond James Financial Advisors are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.