When Roth Accounts Are The Wrong Choice

Who Should Avoid Roth Retirement Accounts? Key Scenarios Where Pre-Tax May Win

Join us from our new recording studio as we explain when Roth retirement account benefits like tax-free withdrawals and no required minimum distributions, are not ideal for everyone. We contrast Roth versus pre-tax taxation timing and outlines cases where Roth contributions may be disadvantageous. Scenarios include people currently in much higher tax situations than they expect in retirement, those likely to move from high-tax states to lower-tax states in retirement and borrowers on federal income-driven student loan repayment who can lower payments via pre-tax contributions. Tune in and see if a Roth is right for you (or not)!

00:00 Roth Hype vs Reality
00:14 Show Intro and New Studio
01:51 Why This Roth Episode
03:06 Roth vs Pretax Basics
05:31 High Taxes Now
10:07 Retire to Lower Tax State
12:17 Newsletter Break
12:35 Student Loans and AGI
13:57 Cash Flow Crunch
16:19 Near Retirement Medicare Traps
18:34 When You Have Other Assets
20:01 Wrap Up and Thanks

Transcript

SPEAKER_01 0:00

As beneficial as Roth retirement accounts can be, they can have some real downsides as well depending on the rest of your financial strategy. In this episode, we talk about specific people who should avoid using Roth accounts. Let's get started.

unknown 0:13

Let's get some money.

SPEAKER_01 0:14

From New Money New Problems, it's the New Money New Problems Podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles they've never seen. Negotiating compensation, purchasing your first investment property, helping your family with money. The highs and lows of entrepreneurship. New money brings new problems that require new solutions. Join us as we work through them together. I'm Brenton Harrison, and this is the New Money New Problems Podcast. Hello and welcome to another week of the New Money New Problems Podcast. I hope that you have had a phenomenal week thus far. I will tell you, this is probably as excited as I have been in a while coming into a new episode of New Money New Problems because we are officially recording in our new recording studio. I know I have been teasing this for over a year, but it has taken some back and forth. In the middle of the project, we actually had an ice storm that caused some damage to our home and my office, but I can finally say that we've got fresh paint on the wall, new camera, new microphone system. If you have not checked out our video in the past, this week is the week. And we're definitely going to link to our YouTube channel in the show notes so you can check out our video if you haven't already and join in the celebration with me. But even beyond that, we're considering making this a video podcast so you can watch directly on your favorite platform and see through that platform some of the scenarios and illustrations that I've gone through in the past that to this point you've only been able to see on YouTube. But enough of that, let's get into the purpose of today's episode. And that is all about Roth retirement accounts. A few weeks ago I did an episode about the things that I would do differently if I had to start over financially. And one of the things that I shared was if I had to start over financially, I would not focus on putting as much into my retirement accounts as I possibly could. As a matter of fact, I would do the reverse. I would do as much as I could to make sure I wasn't leaving any money on the table, such as through a retirement match from your employer. But beyond that, I would have my focus be on building up investments and cash reserves that I could access in the here and now. Now, in that episode, we didn't talk much about Roth retirement accounts, but if you do any basic Googling or searching or chat GPTing about retirement accounts, you will see people singing the praises of Roth accounts. And if you're reading that, you can go wholeheartedly into the Roth camp without understanding that there are some subtleties based on the rest of your financial strategy that can make a Roth account just something that's not an ideal strategy for you. So today's episode is not about downplaying Roth accounts at all, it's more about highlighting the specific scenarios that you could fall into or that could apply to you that would make you not a great Roth candidate. And to be fair, before we even get started, let's go through what some of the benefits of a Roth account are in the first place. As a recap, if you're looking at a Roth versus pre-tax, it all has to do with when you pay taxes. If you do things right, you only pay taxes either going in or coming out when it comes to these types of investments, but not twice. With a pre-tax account, it is exactly how it sounds. You make contributions that go into the account before you've paid taxes. As an example, let's say that you get a $10,000 paycheck and you decide to put $1,000 into your account pre-tax into your 401k, your 403B, what have you. Now, if you were subject to a flat 20% tax rate, you've now taken the amount on which you'll pay taxes from $10,000 down to $9,000. If it were $10,000, 20% would mean $2,000 in taxes. But because you made that $1,000 contribution pre-tax, $20 on $9,000 is only $1,800 worth of taxes. You have saved yourself $200. Conversely, with a Roth account, it's the exact opposite. You pay your taxes on the front end. You get a $10,000 check, you put $1,000 into your Roth account from a tax perspective, it doesn't matter. You're still going to pay that 20% on the full $10,000. But in exchange, if that account grows to a million dollars as a Roth, when you take out $30,000 in the first year, you pay no income taxes on those funds. And there are other benefits as well. A huge one being that you don't have required minimum distributions with Roth retirement accounts. A required minimum distribution is essentially the government saying, you've gone so long with this investment account and haven't paid taxes on these funds, at a certain age we're going to make you start taking withdrawals whether you need the money or not. And this is a huge burden for people with pre-tax retirement accounts because if you've done extremely well and don't need all those funds, the government essentially says, we don't care, you gotta take some out so we can tax you as income as we originally intended, because to this point you haven't paid them. There are other benefits tied to things like Medicare, which we'll discuss more on in this episode. But suffice to say, with a pre-tax retirement account, there's the possibility that the amount that you take out each year could increase the amount that you pay in Medicare on a monthly basis. So again, in all fairness, Roth accounts have a lot of benefits. But now let's get to today's purpose and tell you some reasons why you would avoid them in a certain year or a certain period of years. And we're going to start with people who are currently in a higher tax environment than they are likely to be in their retirement years. Believe it or not, as much as we complain about taxes, we actually live in an extremely low tax environment for most people. There are all these levers you can pull, especially if you're a business owner, a property owner, if you're charitable, if you have children, if you have all these different types of expenses where you look at the amount that you would have paid in taxes before those levers were pulled and the amount that you actually paid, and it's not as much as most people expect. There are some people out there, however, where that's not the case. They are paying significantly more in taxes now than they're likely to pay in retirement. And in many cases, these are people who do not have access to the same levers. Let's look as an example at a person who earns $300,000 of taxable income as a single tax filer in the state of California versus a married household that earns $300,000 of taxable income in the state of Tennessee. And you've heard me say that we live in a progressive tax bracket. Every single income or dollar that you earn is not taxed at the same level. So while they won't pay that on average for every dollar that they earn, the highest portion of their income is taxed at 24%. Now they're living in the state of Tennessee. I live in the state of Tennessee. In Tennessee, there is no state income tax. So quite literally, the highest tax rate that they would pay for any dollar that they earn absent any other taxes than our income taxes would be 24%. Now let's look at the single person in the state of California with the $300,000 taxable income. We're looking on the left-hand bracket, and you know that the tax brackets for single filers are much more severe. So whereas the married couple had their top tax rate at the 24%, the single person this puts them all the way in the middle of the 35% tax bracket. So not only is that 11% higher in terms of federal taxes, in California they have very high state income taxes as well. Now it's still a progressive stack uh tax bracket, so the tax rate goes all the way from 1% up to 12.3%. But at their $300,000, that actually puts them in the 9.3% bracket. So whereas the married couple in Tennessee has their top portion at 24%, the single person in California on the highest dollar that they earn is going to pay forty-four point three percent on that same top dollar. And even beyond just the basic tax rate that you pay, getting to the taxable income is a process that allows you to take advantage of things like above-the-line tax deductions, below-the-line tax deductions, and below the line tax deductions when you take them, that's called itemizing your taxes. Below the line deductions are things like charitable contributions. They're things like the state and local taxes that you pay, both the income tax and the property tax. If you live in a state that doesn't have state income tax, you can claim the sales tax that you pay on high-ticket items. But even for really high income earners who do itemize their deductions, they may not be able to take advantage of those deductions at the same levels as lower income earners, which is a phenomenon called reverse discrimination. You are earning so much that it restricts you from certain tools that are at other people's disposal. For example, starting in 2026, the amount of state and local taxes that you can claim as a deduction has gone up to $40,000, as long as you don't make above certain levels. For a single taxpayer whose taxable income is above $252,500, their ability to claim that full $40,000 is actually reduced by 30 cents for every dollar there above the limit. For married tax followers, it's double, it's $505,000. So in that scenario where they can't take advantage of the full deduction, they're still paying significant taxes. If you're a single tax file, you don't own property, you're not exceedingly charitable, then you may be stuck following the standard deduction even at extremely high levels of income. Quite literally, I met with someone a few weeks ago who earned over $600,000 of W-2 income as a single preparer and was still using the standard deduction, meaning they were able to deduct less than $20,000 off of that half a million dollar income. It's just not that much. So for that person, I would argue the likelihood that they pay that level of tax in retirement is probably low. They're likely in line to pay less in those years than they are during their working years. And in that scenario, it doesn't make as much sense to do a Roth account and pay taxes at today's rates when that rate could be reduced when they actually start withdrawing the funds. Sticking with taxes, in the previous scenario, we talked about a single taxpayer in California with a taxable income of $300,000, and we compared them to married taxpayers in the state of Tennessee. And in that scenario, we covered that Tennessee doesn't have state income tax. Well, now let's look at the scenario of taking that person who was in California during their working years, and in retirement, they do what many people do in California or in New York. They move to an area with a lower cost of living and possibly an area with low or no state income taxes. So let's take our taxpayer and in their retirement years move them from California to the state of Georgia. And I think you're gonna love this example. You'll recall that during this person's working years, they were single, $300,000 worth of taxable income in the state of California, and that led to them paying 44.3% on the highest portion of their income. Let's assume that when they get to retirement, they've done well, but they're not earning the exact same amount in retirement that they were when they were working. So maybe they're earning $200,000 in retirement income. Well, at the federal level, that knocks it down a little bit, where now the highest portion of their income is taxed at 24%. So that's an 11% decrease in federal tax dollars right off the bat. And whereas in California, they had gotten up to the 9.3% tax rate on the highest portion of their income. If they moved to the state of Georgia for retirement in this example, the reason I chose Georgia is because as you'll see on screen, it says, and I quote, in 1981, Georgia enacted an income tax exclusion for retirement income received by taxpayers age 62 and over. Currently, taxpayers age 65 and over may exclude up to $65,000, while those 62 to 64 may exclude up to $35,000. And since Georgia's top rate for state income tax is 4.99%, not only will this person see a reduction in retirement from 44.3% down to essentially 29%, they also will only have to pay that state income tax on $135,000 worth of earnings because up to $65,000 of it will be excluded from state income tax calculations.

SPEAKER_00 12:22

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SPEAKER_01 12:35

Next up, a huge one that I left for third, so you guys wouldn't accuse me of always talking about student loans on this podcast. But the fact of the matter is if you have federal student loans that you're paying back using an income-driven retirement plan, using Roth accounts is a missed opportunity. The reason why is because literally every income-driven repayment plan that you could sign up for, including the soon-to-be-released repayment assistance plan, uses your adjusted gross income to calculate your payments in some way. And one of the significant ways that you can reduce adjusted gross income, thus reducing your federal student loan payments, is by using pre-tax retirement accounts. Going back to our example for the final time today of a single taxpayer in the state of California, we know that at a taxable income of $300,000, that if they were to max out a pre-tax 401k, for example, at $24,500, it would save them $10,853 in state and federal taxes. Well, in addition to that almost $11,000 that they saved in federal and state taxes, they would also save over $3,500 in student loan payments for a total savings of $14,528.50 for the year, which between taxes and federal student loan payments is a savings of over $1,210 each month. The next group of people that should avoid Roth accounts are people who are trying to do a whole lot with a limited amount of dollars. And I know that can apply to a whole lot of people, but the reality is there are those out there for whom cash flow is just more of a crunch than others, even at a high income. You see this a lot with a particular avatar of a person, and there are a few of them. It could be that you're in the sandwich generation. Maybe you're financially responsible for a parent while also responsible for the younger generation, the kids in your household. Maybe you're not in the sandwich generation, but you have a child in private school. Maybe you have significant student loans and you're paying four figures a month towards your debts, like the person, our example. Maybe you're dealing with all of the above. And with all of that said, you're still trying to save for retirement, still trying to make sure you have emergency reserves, still trying to keep your consumer debt at bay, still trying to put money aside, and as we call it on this podcast, shoot one arrow and hit multiple targets. When all that's going on, every dollar is precious. And I would say that anything that you can do to squeeze a little more out of it is helpful, meaning that missing out on an opportunity to get a tax deduction for the funds that you're putting into a retirement account would be an opportunity that I wouldn't pass over. And in New Money, New Problems, this is our person, right? If you talk to people in the financial advisory space, other certified financial planners, they are not typically targeting the people that we're targeting. They're not necessarily working with people who struggle with cash flow at high incomes. They're working with people who came to them wealthy, they're maintaining their wealth. Yes, they are doing excellent planning, but they're working with people who have the cash flow to do a great many things. They're making way more money than they need in the here and now, and they can take advantage of that by doing things like Roth conversions or contributing to Roth accounts directly to get taxes out of the way, even if they're higher taxes, because they don't want to pay taxes in retirement no matter what. That's not who we work with. We work with the high income earner who could be making $500,000, $600,000, $700,000 per year even, but they still have all these things in their life that are tugging at their attention, tugging at their purse strings, and they don't have endless capital to do similar types of maneuvers. So if that's you, don't think of it as an income thing. It could be you're someone who's making this decision at $70,000, $100,000, or it could be $700,000. It's not about the income, it's about your circumstance. And if you know that you're trying to accomplish four or five different things with the same three or four dollars or three or four thousand dollars, I would not assume that it's worthwhile to miss out on that pre-tax deduction in exchange for avoiding those taxes in retirement, even if it does end up being a higher tax rate in your scenario. Next up are people who are nearing retirement and they either haven't opened a Roth account yet or they're trying to limit the amount they pay for health care in retirement. We don't have to spend a ton of time on this, but what you need to understand is when it comes to Roth accounts, there's a five-year look back period. And essentially, if you're trying to take advantage of the tax benefits where you're taking that money out without paying taxes, the account has to be open for at least five years before you can do so. This means that if somebody is planning to take money out of their retirement account at 60, yet they start putting money into a Roth account at 57 years old, it may not be the best idea if they're trying to access those funds at the start of their retirement. And for people as young as 63, and I know that's very specific, but we'll explain why, they have to be very careful with things like Roth conversions, which is when you take money that's in a pre-tax retirement account, you convert it to a Roth account, and in that conversion, you have to pay taxes on the amount that you transfer over. For example, you take $50,000 from a pre-tax account, convert it to a Roth, it's as if you earned that $50,000 from an income tax perspective. That's extremely relevant because at age 65, they're eligible for Medicare. And the amount you pay for Medicare, parts B and D specifically, are based on your income two years prior. It's not based on your prior year's tax return. So starting at 63, you have to start paying attention to the income that shows up on your tax return because if you do things like Roth conversions in that year that add to your taxable income, two years later, it increases your payment for Medicare Parts B and D. Now, to be fair, the same is true of people who have pre-tax retirement accounts who start taking distributions in these years as well. The point is you have to just be aware of the impact. And if it's pre-tax, Roth, as we've said in the past, what you do in one area impacts other areas and it requires proper planning. Lastly, and this group is not as much about people who have to avoid it as much as it is people who have flexibility, or those who have significant non-qualified assets, money in a brokerage account, other different investments. Maybe they have cash flow from things like real estate property or other businesses. And the reason I don't think these people have to be incredibly concerned with Roth accounts in certain scenarios is they have other mechanisms they can use to access money that's tax efficient. If you have real estate and you can take advantage of some of the tax benefits we talked about in the episode for people who should consider real estate, there are ways to receive tax-advantaged income that don't require you to access your pre-tax or post-tax retirement account. If you have significant non-qualified investments, whether it's things like tax loss harvesting or having a more stock-centric portfolio that allows you to be more specific when you're taking money out of your account in terms of what will generate the biggest capital gain or smallest gain, or even taking an intentional loss, they are just all these different things that you can do where your only resource is not that retirement account. So we have people who build a bridge, a rhythm that they use when they need money from their accounts. They figure out where's the best place to take it. Is it from a Roth account? Is it from a pre-tax account? Is it from a brokerage account? Another tool in their portfolio. And for these people, again, they can choose to use retirement accounts that are Roth accounts, but they don't necessarily have to because of how well positioned they are. So I know that's a lot, but I hope this was beneficial. I hope that you are checking out the video and show some appreciation for not just the studio, but also my wife. I didn't share at the beginning of the episode that my wife was solely responsible for setting up this studio from buying the equipment to setting it up to the paint that you see behind you, which she hand painted. So as I said at the beginning, I'm really, really excited, and I hope that the lessons that you learned in this episode were useful. And I'll be right back here next week with a new episode for you. Talk to you then. From New Money New Problems, this was the New Money New Problems Podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles that they've never seen.