Roth IRA doesn’t seem good

[rollergrrl]

Let’s say you have 1 million in a tax deferred account and withdrawal the recommended 4%. That would be $40,000 a year. Taxes on that $40,000 would be very small after you subtract $24,000 for the married standard deduction. So you would only be taxed on $16,000 at 10%.

Why would you rather be taxed now and put the money in a Roth when you are in the 22% or higher tax bracket? Why are people saying the Roth is so much better? What am I missing?

 

[cusetownusa]

Let’s say you have 1 million in a tax deferred account and withdrawal the recommended 4%. That would be $40,000 a year. Taxes on that $40,000 would be very small after you subtract $24,000 for the married standard deduction. So you would only be taxed on $16,000 at 10%.

Why would you rather be taxed now and put the money in a Roth when you are in the 22% or higher tax bracket? Why are people saying the Roth is so much better? What am I missing?

Who is saying the Roth is so much better? Not sure I have heard that before.

Generally the advice is to max out tax deferred space and then max out the Roth space before contributing to a regular tax account.

The general advice might change for lower income households.

 

[Anna J]

Is this the only form of income you plan on having? If so, then your reasoning seems good to me.

I will have a pension and hopefully SS at some point so my taxable income would be a lot higher than the 40k. I have $ in roth, traditional and regular taxable accounts for greater flexibility.

In the end it will depend on your own situation and what you are comfortable with.

 

[njhowie]

Why would you rather be taxed now and put the money in a Roth when you are in the 22% or higher tax bracket? Why are people saying the Roth is so much better? What am I missing?

Because all of the investment gains in the Roth will come out tax free. Gains in the tax deferred account are going to be taxed like the rest of it.

 

[foxfirev5]

Around here Roth's are saved for later in your retirement or to minimize RMD's at age 70. By then you'll also have Social Security and other assets to consider. Hopefully you'll be so rich that you have a higher tax bracket. However the downside is that you're old.

 

[powerplay]

This is highly dependent on the individual situation. If you have a pension, sell some property or stock, and/or have RMDs from another retirement account that 10% tax rate could be quite a bit higher and you could pay higher rates for medicare. Living in a state with income tax would also add to the taxes paid on a traditional IRA withdrawal.

 

[GrayHare]

Much of the Roth discussion here centers around converting from traditional IRA during the years after FIRE when other income is low. During that pre-pension, pre-SS period, converting to Roth gradually can incur a low tax rate.

 

[kgtest]

Much of the Roth discussion here centers around converting from traditional IRA during the years after FIRE when other income is low. During that pre-pension, pre-SS period, converting to Roth gradually can incur a low tax rate.

Bingo. Part of a lot of folks recipe for life after FIRE.

 

[Curmudgeon]

To add some numbers - if you have $1million in that IRA when you hit age 70.5, RMD's will likely force you to take out over 70K per year, and pay taxes on it, whether you need it or not. Add to that whatever other income you may have (SS, etc.) and you're in a higher tax bracket than you were in when you were only taking out $40K per year.

 

[Plantman]

Here's the way I see it. Let's say you put in $5000 per year for each you and your spouse for 30 years. That's $300,000 that you pay taxes on. However when you go to start taking it out it's probably grown to well over a million and that will all be taken out tax free!

 

[pb4uski]

Let’s say you have 1 million in a tax deferred account and withdrawal the recommended 4%. That would be $40,000 a year. Taxes on that $40,000 would be very small after you subtract $24,000 for the married standard deduction. So you would only be taxed on $16,000 at 10%.

Why would you rather be taxed now and put the money in a Roth when you are in the 22% or higher tax bracket? Why are people saying the Roth is so much better? What am I missing?

A Roth is beneficial only where your current marginal tax rate is lower than your expected marginal tax rate in retirement. In many cases, your marginal tax rate while working is higher than your marginal tax rate in retirement.

However, if you ER there is period of time before pensions and SS begin where it is very beneficial to do Roth conversions.

You're missing SS and pensions and income from taxable accounts... let's say you have $20k pension and $40k in SS and $10k in taxable account income.. that's $70k so before you do that tIRA withdrawal or RMD you are already solidly in the 12% tax bracket... so on the $40k you might pay $7k or so in tax (some at 12% and some at 22%).

OTOH, if you are in the same situation before pensions and SS start you have $91k of headroom ($77k top of 12% tax bracket + $24k standard deduction - $10k of taxable account income) so if you do a $91k Roth conversion you pay ~$8k in taxes.

So would you rather pay $8k in taxes on $91k of Roth conversons (8.8%) or $7k on $40k of tIRA withdrawals (17.5%).

I prefer 8.8%.

 

[pb4uski]

Here's the way I see it. Let's say you put in $5000 per year for each you and your spouse for 30 years. That's $300,000 that you pay taxes on. However when you go to start taking it out it's probably grown to well over a million and that will all be taken out tax free!

It doesn't matter if the marginal tax rate is the same.

Let's take your first year contribution of $5,000 and let's say the tax rate is 20% to make the figuring easier. You have earned $6,250 and have two choices: defer $6,250 and pay no tax now or pay $1,250 in tax now and put $5,000 in a Roth.

Both accounts earn 7%/annum.

30 years later, the tax-deferred account is worth $47,577 [$6,250 * (1+7%)^30] and you take it out and walk away with $38,061 after paying $9,515 (20%) in taxes.

30 years later the Roth is worth $38,061 [$5,000 * (1+7%)^30]

Mathematically, unless your tax rate is different then it doesn't matter. Now if your tax rate in retirement is 15% then the tIRA is worth $40,440 so you are better off having done the tIRA than the Roth. Conversely, if you have been spectacularly successful so your tax rate in retirement is 25%, then the tIRA is only worth $35,682 and you would have been better off with the Roth.

 

[Animorph]

It's all tax dependent, and may require a favorable taxable/tax-deferred allocation. And maybe a little luck at predicting tax rates, investment gains, and personal needs.

Figure out your taxes at age 70, when you have to take RMD's. In fact the RMD for age 73 is 1/24.7 = 4.05%, and they only get higher after that. Kind screws the taxes, though you don't have to spend it all. Given that I've liquidated all of my taxable accounts by then, the only "voluntary" portion of my income will be how much to withdraw from the tax-deferred accounts, at least some of which (maybe all due to SS) will be at my marginal tax rate.

I'm 63 now, with no income other than taxable investment distributions and capital gains. I can do pretty much what you're suggesting. Except if I keep going like that, SS and a pension and RMD's will give me a marginal tax rate of 24% or more (28% if tax rates revert, higher if anyone cares about the deficit). So at the very least I need to Roth convert whatever I can now at less than a tax cost of 24% (or whatever).

In fact there is also a benefit to Roth converting even if the tax rate of the conversion and the later withdrawal is the same. It's equivalent to being able to contribute some of your taxable account to your Roth IRA. So, if you are paying taxes on a significant taxable account, like me, it's worth it to go ahead and hit the top of the 24%/28% bracket using Roth conversions. Especially with a long time between conversion and withdrawal.

Also if you currently file jointly and one spouse dies before the other, imagine what your taxes will look like as a single. Probably too late to Roth convert then.

And yes, you might not want to Roth convert everything and die with only a Roth account. Though that might be easier to manage. Leave enough in the traditional IRA accounts to fill in the lower tax bracket(s). Then make Roth withdrawals to avoid going into a higher tax bracket. The whole idea is to get that traditional IRA money out at the lowest tax rate.

I think this will be my last year of really big Roth conversions. The next 10 years will have small conversions up to the 10% bracket with capital gains overfilling the 0% CG "bracket". After that SS and RMD's hit and we'll just fill up the 22% tax bracket with traditional IRA withdrawals and use Roth withdrawals as needed.

There is also a possibility that we could go for healthcare subsidies for the next 2+ years, but I have most of a year to figure that out.

Lots of complications there, but my general rule of thumb is to withdraw from the traditional IRA when I can at lower tax rates (or equal) than RMD's will see, and if I don't need the withdrawn funds for expenses it becomes a Roth conversion. That should get you at least 80% of the benefits without all the calculations.

 

[CardsFan]

To add some numbers - if you have $1million in that IRA when you hit age 70.5, RMD's will likely force you to take out over 70K per year, and pay taxes on it, whether you need it or not. Add to that whatever other income you may have (SS, etc.) and you're in a higher tax bracket than you were in when you were only taking out $40K per year.

While your point is correct, the RMD on $1million at age 70.5 is more like $36,500.

 

[pb4uski]

I think the $40k was a placeholder for discussion purposes... but it doesn't take long before the RMD is 4%... just a few years later when you are 73.

 

[CardsFan]

But Curmudgen was saying $70,000!

 

[PatrickA5]

Let’s say you have 1 million in a tax deferred account and withdrawal the recommended 4%. That would be $40,000 a year. Taxes on that $40,000 would be very small after you subtract $24,000 for the married standard deduction. So you would only be taxed on $16,000 at 10%.

Why would you rather be taxed now and put the money in a Roth when you are in the 22% or higher tax bracket? Why are people saying the Roth is so much better? What am I missing?

Wouldn't it be better to have both? Why not take $24,000 out of your Traditional IRA and $16,000 out of your Roth IRA and pay ZERO taxes. That's the power of having both tax deferred and tax free retirement accounts.

 

[pb4uski]

But Curmudgen was saying $70,000!

I just assumed that Curmudgen is older than us young buck and does so his RMDs were higher... if his is $70k that would put him at about 86.

 

[Curmudgeon]

I just assumed that Curmudgen is older than us young buck and does so his RMDs were higher... if his is $70k that would put him at about 86.

Nope, I was just plain wrong. I'm actually a young Curmudgeon, and so I haven't yet looked into the calculations for age 70 RMDs. However, I'm currently taking RMD's for an inherited IRA, and for that, the IRS assumes that I will live to age 83, and wants me to withdraw the money by then. I am surprised to see that, for the regular RMD's, they expect you to live to age 97! So the RMDs are much lower.

Sorry for the bad info.

 

[Jerry1]

I see two situations that apply to me - someone who was in a higher tax bracket during work than in retirement.

1st - If I had a couple years of already taxed money to live on, I could convert tIRA to a ROTH all they way up to either the point of paying no tax or up to the point of one of the lower tax brackets and lock in a lower tax bracket on that money. As has been said, as future amounts come in, I may raise into the higher brackets and then it's less worth it.

2nd - This is my actual situation. I wasn't able to do any ROTH contributions while working due to my income level and company 401K. However, I have money that has already been taxed. While it's not much ($13,000 total, for me and DW), any money I put in there can grow tax free. So I max that out and put that 100% in a stock fund and hope it grows like crazy. It may just help my heirs or me in my last days, but it seems worth it to me.

 

[Perryinva]

Wouldn't it be better to have both? Why not take $24,000 out of your Traditional IRA and $16,000 out of your Roth IRA and pay ZERO taxes. That's the power of having both tax deferred and tax free retirement accounts.

Because it depends on what taxes were paid on the Roth to build it. To get $16k from a Roth requires a $400k Roth, so much has to be from conversions if that is your only savings. If you put the max in, over 20 years & your Roth doubled in value, you paid the equal of half the tax rate paid, up front, but still be well short of $400k, so the rest would be conversions up to the top of 10% bracket. . That has to be compared to the rate paid on the tIRA. The OP example is fairly useless, of that I agree totally. No one interested in tax efficiency has $1M Roth in retirement as their only income, never having converted. As stated, the intelligent approach one would always fill deferred first, then Roth, possibly except when starting out ones young career when if married & paying low tax rates. Then convert when if/when it makes sense tax rate wise. Once the fixed income in retirement after RMDs is guaranteed to set the marginal rate, then conversion pre 70.5 can be assessed. Especially useful for younger DWs expecting to outlive older DHs and not remarry the last 10–15 plus years.

 

[Curmudgeon]

I wasn't able to do any ROTH contributions while working due to my income level and company 401K.

You still could have done backdoor Roths, for you and your spouse. (Just mentioning this for anyone who may still be in that situation). When doing a backdoor, you're using money that you've already HAD to pay tax on, so at that point the only question is "Do I want this to grow tax-free, or do I want it in a taxable account"? The math is pretty easy on that one. Wish I'd learned about backdoors earlier!

 

[Cobra9777]

...there is also a benefit to Roth converting even if the tax rate of the conversion and the later withdrawal is the same. It's equivalent to being able to contribute some of your taxable account to your
Roth IRA. So, if you are paying taxes on a significant taxable account, like me, it's worth it to go ahead and hit the top of the 24%/28% bracket using Roth conversions. Especially with a long time between conversion and withdrawal...

Can you perhaps explain this further?

 

[kaneohe]

Can you perhaps explain this further?

I think what Animorph means might be something like this:
Assume you have 10K in TIRA and 25% tax rate
1) If you convert TIRA and pay 25% tax from TIRA you end up w/ 7.5K in Roth.
After N yrs, it doubles to 15K vs
2) Leave TIRA alone. After N yrs it doubles to 20K. You pay 25% tax and end up after tax with 15K, the same as Roth conversion in 1) above.

However if you pay conversion tax from taxable account instead, it goes like this. Assume you have 10K in TIRA, 2.5K in taxable acct, and 25% tax rate.
3) You convert TIRA and pay 25% tax from taxable account. You end up with 10K in Roth. After N yrs, it doubles to 20K.
4) Leave TIRA and taxable account alone. After N yrs you end up w/ 20K TIRA and 5K taxable. The TIRA after tax is worth 15K. The taxable account has appreciated 2.5K . You pay 15%CG taxes of 0.37K and end up with 4.63K. You have after tax a total 19.63- K so the Roth is larger. The difference is even larger because the taxable account probably had dividends along the way which were taxed (tax drag). The longer the time period the greater the difference will be.

Basically by using the taxable account to pay the conversion taxes, you were able to stuff more into the Roth to gain the advantage.

 

[ArkTinkerer]

The other reason for a Roth is the title of this website. Early Retirement. If you need funds to carry you between retirement and the allowable withdrawal age for tax deferred accounts you can use any of the funds you put into the Roth that are over 5 years old. When matched with partial conversions, this makes what is referred to as a "Roth Ladder". Google it or search for it here. I also strongly second the prior comment about having diversity in the types of accounts you have. Just like having diversity in your investments, having diversity in your account types gives you flexibility in how you withdraw funds allowing you to minimize taxes.