For the right person, a Roth IRA can be a great retirement savings vehicle over the long term. So much so that some people may feel that it is always the right choice, no matter what. After all, tax-free income sounds great. However, like anything in your retirement planning journey, this decision on pre-tax versus after-tax contributions will require understanding the nuances of your specific situation.
How to Consider Pre-Tax vs. After-Tax Contributions
The main advantage of a pre-tax traditional IRA is that you can invest more money over the long term. In theory, any money you save from pre-tax contributions is capital available for further compounding benefits.
The main advantage of a Roth IRA is that you save on taxes in retirement compared to pre-tax accounts, where those taxes are simply deferred. With these, you ultimately pay income tax on both contributions and returns. With after-tax accounts like Roth IRAs, you don’t pay any money on your return because your contributions have already been taxed.
For example, let’s say you want to invest $1,000 from your paycheck, but pay an effective tax rate of 20%. With a Roth IRA, you must pay $200 in taxes first, then invest the remaining $800. With an IRA, you’ll save $200 in taxes and can invest the entire $1,000.
Then, let’s say this account doubles in size and you withdraw it. Your Roth IRA will grow to $1,600 and you’ll keep it all. Your IRA will grow to $2,000 and you will pay $400 in taxes, leaving you with $1,600 again after taxes. (Note that this situation has been simplified for demonstration purposes.)
So, how do you choose? You are generally better off choosing this when you expect to pay higher tax rates.
More specifically, if you pay more taxes during your working years than you currently expect in retirement, the ability for a traditional IRA to help you wait on taxes and cut your contributions in the meantime could theoretically be a great option. Will be better than. If you’ll be paying a higher tax rate during retirement, tax-free withdrawals from a Roth IRA may work better.
Using our example above, let’s say you invest $1,000 while you’re working and earn 100% in returns by the time you retire. Let’s also assume that while working, you paid 20% in taxes, and then 10% when you’re withdrawing in retirement. At retirement, your balance will be $1,600 in the Roth IRA versus $2,000 in the traditional IRA. But then taking taxes into account, your Roth withdrawal would be worth $1,600 without any taxes, while your traditional IRA withdrawal would be worth $1,800 after subtracting 10% in taxes from your balance. Again, because you’re paying more in taxes while you’re working, a traditional IRA is more ideal.
On the other hand, let’s say you pay 20% in taxes currently and 30% when you withdraw the money in retirement. Then, the value of your after-tax Roth withdrawal will still be $1,600, but the value of your traditional IRA withdrawal after the 30% tax rate will only be $1,400. In this reverse case, you may be better off with a Roth IRA.
Should You Focus on Roth Contributions?
Remember that Roth IRAs have a cooldown, as you cannot withdraw earnings from your Roth IRA for five years after you create it (although you can withdraw your original contributions). Unless you plan on early retirement, this probably isn’t an issue, but it’s worth noting.
As always, if you plan to make equal contributions regardless of the tax benefits, you may be wise to switch to a Roth portfolio. You’ll want this money lying around for a while, but with $2.5 million in your 401(k), one can theoretically afford it. Make your Roth contribution, leave it there until age 80 and get 20 years of tax-free growth later in life.
Otherwise, you may want to compare tax rates. Looking at your 401(k) balance, you’re probably at or near the peak of your career earnings right now. So chances are you’ll pay a higher tax rate now than in retirement.
This will typically make pre-tax 401(k) and IRA contributions more valuable than a Roth IRA, because you’ll get more benefit from investable capital than future tax savings. But, if you expect to pay higher taxes after you retire, the future savings of a Roth IRA may outweigh the investment opportunities of your 401(k).
Should you switch to Roth contributions or rollover your account?
Finally, there’s always the Roth IRA rollover option.
Changing contributions at age 60 raises two specific issues. With only a few years left until you retire, your 401(k) will be significantly larger than any Roth IRA you create, meaning you’ll still pay taxes on most of your retirement savings. You can only contribute up to the age 50+ catch-up Roth IRA maximum, which is $8,000 for 2024 and much less than the $30,500 annual limit for a 401(k).
A rollover can fix both of those problems.
With a Roth IRA rollover, you move all or part of your money from a pre-tax retirement portfolio to a Roth IRA. You can then make new contributions to this account, or you can contribute the full $30,500 to your 401(k) and roll those assets into a Roth IRA each year.
However, remember that you have to pay tax on the full value of your rollover. Putting it all together, this would mean adding $2.5 million to your taxable income in a year that is applied to your 401(k). However, before taking such a step, it would probably be a good idea to discuss it with a financial advisor.
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At age 60, converting your retirement contributions to a Roth IRA may not yield much benefit. But this may depend on several factors, particularly your total contributions and how your tax rates will change from work to retirement.
Roth IRA Rollover Tips
- A financial advisor can help you create a comprehensive retirement plan. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with three verified financial advisors serving your area, and you can have a free introductory call with one of their advisors to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to roll your 401(k) into a Roth IRA, there are a lot of moving pieces you need to pay attention to. Read SmartAsset’s comprehensive guide to learn more.
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