Warren Buffett once famously described compounding as the “8th wonder of the world.” It is indeed powerful. Sadly, in a traditional (pre-tax) retirement account, one of the things you’re compounding is future tax liability since all dollars are taxed as income upon withdrawal and even your family faces taxes on distributions after your death.
Instead, you can enjoy tax-free compounding with Roth savings. With Roth contributions, you still save in your workplace retirement plan, but you agree to show contributions as taxable income in the year earned. You give up the tax break today on the deposits to take advantage of tax-free withdrawals in retirement, provided you are age 59½ or older and the Roth account has been established for at least five years. Now, that’s the kind of compounding we like. Roth accounts pass to your family income tax-free too.
You still earn any company contributions, regardless of which tax treatment you select. But keep in mind that any company money contributed would still be made in pretax dollars and would be subject to income tax when withdrawn.
If you’ve been told by your tax advisor that you earn too much to contribute to Roth, this might be right…but, just in Roth IRAs. There are no income limits to save in workplace Roth accounts.
While the upfront tax break has always been one of the most attractive features of saving in a workplace retirement plan, Roth contributions with tax-free compounding of all earnings could end up being an even better deal for many. Plus, Roth dollars aren’t subject to the age 73 and older annual Required Minimum Distributions (RMDs).
Consider Converting To Roth
Many workplace retirement plans allow you to convert existing balances to Roth. Any amount converted is considered taxable income; however, no early withdrawal penalties are charged. Partial conversions are permitted; you decide how much to convert in any given year. After your savings
are converted to Roth and taxes are paid on the
balance today, all future gains will be
income tax-free.
You should have sufficient assets outside the plan to pay the taxes owed upon conversion. No mandatory tax withholding will apply when you convert. You may request an additional distribution to pay for the taxes ONLY from balances that are already eligible for distribution (rollover accounts and pre-tax balances after age 59½). But beware: that amount may be subject to the 10% early withdrawal penalty tax since you are not converting that portion of your savings. Plus, if you pay taxes from your pre-tax accounts, you’ll have fewer assets to convert, and you will lose the opportunity for those assets to grow tax-free in the Roth.
Some recordkeepers charge a fee for each Roth conversion, so make sure you understand the fees you will be charged.
So, Which is Better?
There is no way to tell if pre-tax savings or Roth savings are better since we have no way of knowing what future income tax rates will be. We think having both tax treatments in retirement is ideal so that you can control your tax bracket in retirement. You could pull from pre-tax accounts just enough to “fill up” the lower tax brackets, then use the tax-free Roth assets to supplement your income. Plus, Roth withdrawals don’t count as income for determining the amount you pay for health insurance on the National Exchange.
Did You Know?
Your employer sponsors this financial wellness benefit. Francis provides personal and uncompromised financial advice on all money matters – without any hidden sales angles. Our advice is always conflict-free, meaning we won’t make money off your investment decisions. Best of all, there are no costs to meet. Fees for this benefit are either paid by your employer or your retirement plan.
Our sole desire is to help you achieve the Work-Life-Money Balance that leads to strong financial futures and more fulfilling lives, inside and outside of work. Visit our website,
FrancisWay.com, to explore the features available
to you in your “Participant Portal.” Then, book a
meeting with your financial planner!
