Welcome to Part three of our introduction to Roth. Today we wrap it up and look at some things to consider before you pop the question to a Roth. The fundamental question to ask yourself is “Will I make more income in retirement than I do now?” With Roth you pay income taxes now. Then you don’t pay any tax on what that money earns, forever. General wisdom is that most people have less income and will be in a lower tax bracket in retirement. If this is you, investing in a Traditional account now is better, not Roth. Overall, you pay less income tax and have more savings left to live your best retirement life. So let’s do some brainstorming and see if this fits you.
Are you new to the work force? You're probably not earning much. If you stay in until you are eligible for a pension, your retirement pay will be a percentage of the salary you earn in last few years of your career. You will also be getting Social Security, and have Traditional TSP withdrawals to pay tax on as well. So less income now than in retirement is a good candidate for a Roth. But if money is tight, you may not have the cash to pay the higher tax bill. If you are a FERS employee or BRS military you get a TSP matching contributions of up to 5% of your pay. Prioritize getting to that full match first.
What if you think you will make less later in your career? Or you are unsure. A lower or no pension at all, less Social Security, and less TSP, 401k, or IRA distributions to take might put you in a lower tax bracket in retirement. Better NOT to make that commitment to Roth and pay the income taxes now. Make Traditional contributions and pay that lower tax later.
As you get closer to retirement age and your future looks clearer. You can go to the Social Security website and get an estimate of your Social Security benefits. If you are eligible for a military or government pension, you can estimate that. If you'll work part time in retirement, add in that income.along with what you will need to withdraw from Traditional retirement accounts for living expenses. How does your current income compare to your retirement income estimate? If you’ll be in a lower tax bracket in retirement, you don’t want to pay more tax now with a Roth contribution. Give Roth a pass and stick with Traditional.
Don’t forget that if you have or a Traditional TSP, 401k, or IRA you will have to take Required Minimum Distributions, and pay taxes on them, each year beginning at age 72. Even if you do not need all that money for living expenses right away, you are required to take out a certain amount from your Traditional retirement savings (called distributions) and pay taxes on those distributions each year. If you were a good saver and your investments grew well, these required distributions may bump you up into a higher tax bracket.
It might pay to convert or rollover some of those Traditional funds into a Roth account during that lull in income from when you retire to age 72. You could move enough to “fill up” your tax bracket. You pay less taxes on what you move each year until 72 while in that temporary lower tax bracket, than you would after 72 when you have to start those Required Minimum Distributions. If you’re already maxing out your yearly contributions and you go through a period at some point where your income will dip down into a lower tax bracket, then back up, it may be worthwhile to convert or rollover some of your existing Traditional account to a Roth account.
But beware there are A LOT of rules and possible tax consequences when moving money between the 401k/TSP and IRAs and within the IRA family. Honestly, it’s not a good time to go it alone. It is a great opportunity to tap into the expertise of a financial planning or tax professional.
Kathleen Cannon:
Welcome to part three of our introduction to Roth. In Episode 28, we did a Roth Meet and Greet, where we talked about retirement accounts with the first name Roth, and then jumped into retirement accounts with the last names tsp and 401k. We took the entire episode 29, to talk about the complicated IRA family, and its three offspring, including Roth IRA. Today, we wrap it up and look at some things to consider before you pop the question to a Roth. So if you've been asking yourself, should I make a commitment to Roth now or not? One of the fundamental questions to ask yourself is will I make more income in retirement than I do now, with Roth, you pay income taxes now, once and done, then you don't pay any tax on the money it earns forever. When you pull the money out of a Roth account in retirement, every dollar goes in your pocket to pay bills or enjoy life. When you pull $1 out of a traditional tsp 401k or IRA, you have to pay income tax on it first. If you have $100,000, in traditional tsp, and you're in the 22% tax bracket in retirement, you don't have $100,000 to live on, you'll only have $78,000 to live on after paying income taxes. First off, let's get clear on what I'm talking about when I say tax bracket. Our us income tax system is progressive. That is, the more money you earn, the higher the percent of the tax you pay. For example, if you're single, and earn $12,550 a year, and take the standard deduction, you pay zero income tax, you're in the 0% tax bracket, earn $1 more a year, and you pay 10% income tax on that dollar, and each dollar after that until you hit $22,500 of income for the year. Then you jump to the next tax bracket, which is 12%. The brackets are like a set of stairs, we would say you're in the 12% tax bracket, if that's the step you're on right now. But you didn't pay 12% tax on everything you earned. Remember, you paid 0% on the first step or bracket of income 10% on the next bracket, and now 12% on each additional dollar you earn until you hit the next bracket, which is 22% and so on all the way up to 37%. Okay, so back to Roth. You may be thinking that giving up money now to pay income tax on a Roth contribution. It's a pretty big commitment. General wisdom is that most people have less income and will be in a lower tax bracket in retirement. If this is you, investing in a traditional account now is better not Roth. You put off or defer paying that income tax until you're in that lower tax bracket in retirement. Overall, you pay less income tax and have more savings left to live your best retirement life. Easy peasy. dust off that crystal ball. Look decades into the future. Check out that retirement income tax bill and you'll know whether to Roth or not to Roth. Oh, your crystal ball has been on the blink lately. Yeah, mine too. So let's do some brainstorming and see if we can think of some situations where you might not fit the mold, where you might be in a higher tax bracket when you retire. And a Roth choice may be a good fit for you pretty new To the workforce, or a first term service member, recent college grad, it's hard to know how much you'll be making way out in retirement. But let's face it, you do know what you're making now starting out. And that might not be very much. If you're a military or work for the government, take a look at the page chart. If your salary is near the bottom, your retirement income may well be higher. If you stay in until you're eligible for a pension, your retirement pay will be a percentage of the salary you earn in the last few years of your career. It's up or out in the military. So your pay will definitely go up if you stay in. If you're in a government job or civilian job, do you see yourself moving up or taking a supervisory track, your pay would probably go up pretty nicely over your career too. If you're military or a federal employee, you don't get 100% of your final few years pay his retirement pay. But remember, you'll also be getting social security and have traditional tsp withdrawals to pay tax on as well. So less income tax now than in retirement is a good candidate for a Roth. Okay, you youngsters are ready to jump on the Roth bandwagon, right? No, wait, wait, can you think of why that might not be a good idea? Paying that income tax now, so you pay less overall is great. But that money has to come from somewhere. If money is tight, that probably means you would have to contribute less each pay period to your retirement account now, so you have the cash to pay that higher tax bill do. If you're a fers employee, or BRS military, you get a tsp matching contribution of up to 5% of your pay. Many 401k plans also offer a match. If making Roth contributions means you can afford to contribute that full 5% you'll lose out on those matching contributions. That's not such a great deal. So tip number one, prioritize getting to that full match. First, if you want to make Roth contributions, make sure you can afford the income tax, which would be withheld from your pay each pay period and still be able to contribute enough to get your full match. So if you aren't making much money now, but your salary future looks bright, and you can contribute at least enough to get your match. Roth may be the one you wouldn't be locked into that choice for life. As your earnings go up, and you go into a new tax bracket, you can reassess and see if it still makes sense. Or if your expenses jump up, maybe from starting a family, for example, you can always switch back to making traditional contributions. What if you think you'll make less later in the career or you're not sure. That may mean a lower or no pension at all, less Social Security, and less tsp 401k or IRA distributions to take that might well put you in a lower tax bracket in retirement? Better not to make a commitment to Roth, and have to pay that income tax now, make traditional contributions and pay lower taxes later. Why would I want to make less money later in career you ask? That's up to you? Are you thinking of doing one tour, then getting out and trying something new, or starting your own business? wanna retire from the military at 40 and teach school, start a nonprofit or become a missionary or something, or start a family drop out of the workforce, be a stay at home parent for a while. Maybe you're making good money now. But you're a military spouse, or married to a civilian that moves a lot. And don't know if you'll be able to find work at your next duty station. Or you worked so hard to get where you are now, only to realize you hate your job and want to give it up and do something you really love that happens to make less money. No matter your story. If it looks like you will have less income in retirement than you do now. Or it's really uncertain. You're probably better off passing on Roth and contributing to a traditional retirement account. Okay, let's say you're getting closer to retirement, and your future is looking a little clear. No crystal ball required. There's still the same basic question. Will you be in a higher income tax bracket in retirement than you are now? To help answer that question You can go to the Social Security website, get an estimate of your Social Security benefits based on your work history. If you have worked long enough to be eligible for a military or government pension, you can estimate what that will be to. Can't see yourself sitting around the house, I'm thinking of working part time in retirement. Don't forget to add that income in as well. You can also estimate how much additional money you'll need to withdraw from your traditional retirement accounts for living expenses, and then come up with an estimate of what your total income in retirement will be. How does your current income compare to that retirement income estimate? If you'll be in a lower tax bracket in retirement, you don't want to pay any more tax now with a Roth contribution, give Roth a pass, and stick with old traditional. But wait, there's more. Don't forget that you have a traditional tsp 401k or IRA, you will have to take required minimum distributions and pay taxes on them each year beginning at age 72. Even if you do not need all that money for living expenses right away, you're required to take out a certain amount from your traditional retirement savings, called the distribution and pay taxes on those distributions each year. If you are a good saver, and your investments grew Well, these required distributions may bump you up into a higher tax bracket. In this case, some good timing may save you some cash. Let's say as you approach retirement, you're earning good money $100,000 a year, you plan to retire at 65 and get a pension and start taking your Social Security benefits for a total of $70,000 a year. You mostly want to relax in retirement and think you'll need maybe an extra $5,000 for a total of $75,000. To cover expenses and enjoy life. You plan to pull that $5,000 from your traditional tsp or 401k each year and let the rest grow. Your taxable income in retirement will be less than what you're earning now. So it doesn't look like Roth, it will be a good deal. But when you hit 70, to remember those required minimum distributions. If you were a diligent investor and have a balance of a million dollars in your tsp 401k, you will be required to withdraw approximately $40,000 at age 72. These amounts are recalculated every year, and you'll have to take withdrawals every year, or face a big penalty. Now your Social Security pension, traditional tsp 401k. withdrawals add up to $110,000 in that year, which is all taxable and may push you into a higher tax bracket. Here's where some timing may help. It might pay to convert or rollover some of those traditional funds into a Roth account. During that low end income from when you retire to age 72. You could then move enough to fill up your tax bracket. That is you move as much money from a traditional account to a Roth account as you can, without stepping up into that next higher tax bracket. You'll pay less taxes on what you move each year until 72 while in this temporary lower tax bracket than you would after 72 when you have to start those required minimum distributions. So to wrap up, if you're trying to decide between contributing to a Roth or traditional account this year, it's pretty straightforward, though not necessarily an easy decision, you'll need to determine Will you be in a higher tax bracket in retirement than you are now? Yes, consider Roth to pay more tax now, but less taxes over your lifetime. know you'll be in a lower tax bracket in retirement, traditional may be a better way to go. Is it too close to call or just too far in the future to be sure, you could contribute something to each to diversify your tax risk. Just make sure that if you choose Roth, and paying tax now that you can still contribute enough to get your full match. If you can't stick with traditional contributions, so you can get as much of that match as possible. If you're already maxing out your yearly contributions, and you go through a period at some point where income will dip down into a lower tax bracket then back up. It may be worth While to convert or rollover some of your existing traditional account to a Roth account, you may remember from last week, the can only can contribute up to$19,500 a year 26,000. If you're 50 or older, to a 401k, or tsp, if you're contributing the full amount there and want to invest more for retirement, or your workplace doesn't have a retirement savings plan, you can consider investing in an IRA. We went through the three types of IRAs last week, and feel like can be about as easy to comprehend as a dumpster fire. Unlike tsp, or 401, KS, there are income limitations on who can contribute to and defer taxes for a traditional IRA. Also, if you make too much money, you can't contribute directly to a Roth IRA at all. But if you're above both those limits, and a Roth option makes sense for you. There is a backdoor anyone can contribute to a non deductible traditional IRA, you'll have to pay income tax on your contributions, earnings grow tax deferred, and you pay tax on them. When you make withdrawal. You can take advantage of a low income period to pay the tax and contribute to the non deductible traditional IRA, then convert it to a Roth IRA. If you do it quickly, there will be very few earnings to pay tax on when you convert, then once it's in the Roth IRA, it's all tax free after that. And because it's a Roth, you don't have to worry about required minimum distributions at age 72. But warning, there are a lot of moving parts and detailed tax rules around these rollovers and conversions. For example, some 401k plans allow you to convert a traditional 401k to a Roth 401k. tsp does not allow you to convert your traditional tsp to a Roth tsp. But you can consider rolling over a traditional 401k or traditional tsp to a Roth IRA. You may remember from last week's episode, that the IRA family plays by different rules than the 401k and tsp, some good, some not so good. Overall, contributing directly to a traditional tsp or 401k, or Roth tsp or 401k is pretty straightforward. You can be confident that contributing is almost always a good idea, with or without a crystal ball. Today's episode should help you think through deciding whether to choose the Roth or to stay traditional, but be aware there are a lot of rules and possible tax consequences when moving money between the 401k tsp family and the IRAs or within the IRA family. Honestly, it's not a good time to go it alone. It's a great opportunity to tap into the expertise of a financial planning or tax professional. You can establish an ongoing relationship to help with all your financial decisions, or even just hire one to help with this specific issue or pay for advice by the hour. I hope this series has cleared the air a little bit. If you got any questions or you'd like to talk about it more feel free to contact me. You can always reach me at Katie at money pilot advisor comm or through the website.