Savers maxing out their 401(k) plans are likely to hear about one strategy preached endlessly: open a Roth IRA or get taxed to death in retirement.
It can get overblown, but there is a kernel of truth here. Having tax flexibility in your later years is a gift that keeps on giving.
That is because many of us will live long enough to take required minimum distributions (RMDs) from our 401(k) or IRA plans. The age to begin taking RMDs is 73 for those who reach that age between 2023 and 2032. The age increases to 75 in 2033.
RMDs are based on a calculation that combines an IRS estimate of life expectancy and your IRA balance. As the number of years you might live decreases, the amount you must take out, and upon which you will be taxed, increases.
For instance, imagine you have $100,000 in your account and that you are 72 years old. The IRS table shows a divisor of 27.4, so that is $100,000 divided by 27.4. You must take out $3,650 per year, on top of any other income you have, and pay taxes based on your current tax bracket (figures rounded).
Fast-forward 20 years. Your balance has grown with investment, minus withdrawals for living expenses. You now have $200,000.
The IRS table at age 92 shows a divisor of 10.8. (It is not personal. The IRS makes one projection for everyone and must apply it equally.) So the new calculation is $200,000 divided by that figure. Now you must take out $18,519 per year.
You do not have to spend the money, and you can reinvest it, but the tax bill is unavoidable unless your money is in a tax-free Roth IRA instead. RMDs do not apply to Roth IRA balances and any amount you choose to take out is tax-free anyway.
Here is the rub: many people pay taxes on part of their Social Security income, plus taxes on employment income and on realized gains and income in taxable investment accounts. Some people find themselves in a tax bracket in retirement similar to their working years.
That is where having a Roth IRA can help. Being able to choose tax-free income as you need it can be a pivotal part of your retirement income withdrawal strategy.
When you need a Roth IRA
Broadly speaking, Roth IRA strategies are typically a good idea for at least a portion of your retirement funds, even if you are younger and not yet earning much.
Teens can open them and fund them from summer jobs while they do not yet earn enough to pay income taxes and while living expenses are low. That is serious tax-free compounding for life!
Many working-age folks prefer to max out their workplace plans for the immediate tax breaks, and that is a good idea. But if you have an opportunity to save a bit more and can open a Roth, or if your employer offers a Roth 401(k) option for a portion of your contribution, even a minimum investment may turn out to have been your best move of all.
Be aware, you cannot contribute to a Roth IRA if you make too much money today. But those limits are relatively high: in 2024 it was $144,000 for single filers and $214,000 for couples.
That is not most people, but the IRS does not care if you live in a high cost-of-living state such as California or New York and make more as a result. The limits are the limits.
For those high-wage folks, I sometimes end up introducing the idea of the “backdoor” Roth IRA.
There are some key intricacies that are important to understand. First, you have to make a nondeductible contribution to an IRA. No income limits there.
Then you convert the IRA to a Roth. Ideally, the conversion is almost immediate, as any growth between the time of your non-deductible contribution and conversion is subject to tax.
From the conversion point forward, the assets in the Roth grow tax-free and can be withdrawn tax-free later on.
Roth IRAs are also great accounts to pass to heirs. While they must be withdrawn within 10 years, the assets inside continue to enjoy tax-deferred growth and the funds are taken out tax-free.
It is important to consider your Roth IRA strategy in the context of a complete, well-written financial plan and with the help of a qualified tax expert. Tax flexibility later in life could be an important part of a long-term personal financial plan.
