What Is a Roth IRA? What Are Roth 401k Contributions?

Welcome back to The Clark Group Planning Minute! In this article, I want to review with you Roth IRAs vs. Traditional IRAs, and the difference between the two. We often get asked by clients what is a Roth IRA or Roth 401k, and how can we take advantage of these types of tax-free accounts. In addition, I will cover Roth conversions & Roth 401k contributions towards the end.

A traditional IRA is known as an Individual Retirement Account, which acts fairly similar to a company’s traditional 401k plan. The contributions that you put into a traditional IRA are tax deductible, meaning you get an immediate tax benefit for the year in which you contribute into the account. It effectively lowers your Adjusted Gross Income (AGI). However, that money then grows tax-deferred, which means that all the growth within the account will eventually be taxed once you take a distribution out the IRA, typically past the age of 59 ?. Let’s say you’ve been adding into a traditional IRA or 401k over the course of your 40-year working career, and now you are ready to retire with a $2 million 401k or IRA. Unfortunately (for you, not the IRS), you have to pay taxes on the withdrawals you take from that account, with the entire $2 million being taxable at your ordinary income rate (both Fed & State taxes). A common misconception is that people think they will automatically be in a lower tax bracket in retirement than in their working career since they are no longer generating earned income, but that is not always the case. There are retirement income streams such as IRA income, pension income, Social Security PIA income, and even rental property income that could potentially add up to being just as much if not more in retirement than in your working years. Also, we believe that taxes are most likely going to continue to go up during our lifetime due to the Social Security fund needing more funding and our debt rapidly increasing, so planning around these potential tax hikes can be crucial.

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The other account, a Roth IRA, works almost in the opposite manner to a traditional IRA. When you contribute into a Roth account, you don’t get any tax deductions or immediate benefit in the year in which you contribute into that account, you pay the taxes upfront. However, all the growth that occurs within that account now grows tax-free! Yes, Tax-free!… ?That means that if you started early with contributions into a Roth IRA or Roth 401k, let’s say again over a 40-year career, once you retire and pull funds out of the account you avoid taxation on the distributions. On top of that, you can also tap into the cost basis, which are your original contributions, tax-free before the age of 59.5 without any tax penalty. Whereas with the traditional IRA or 401k, if you tried to take out a distribution of the contributions from those accounts, you would have a 10% tax penalty and income tax to pay. However, even though you have the option to tap into the cost basis for Roth accounts, we typically advise using that option as a last resort since these buckets should be earmarked for maximizing growth and retirement distributions.

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Also, with a traditional IRA or 401k, account holders are required to take out a minimum amount from the account each year once they reach a certain age, either 72, 73, or even 75 years old depending on their birth year, and this type of distribution is known as a required minimum distribution (RMD for short). With Roth IRAs, there are no RMDs that need to take place which gives account holders more flexibility with what bucket to pull from, as well as generational planning benefits. As you can probably tell, Roth IRAs can create a fairly significant tax and income advantage for clients.

Another strategy available to people is what’s called a Roth conversion, whereby you can convert a portion or even all of your traditional IRA or 401k into a Roth IRA by paying taxes on the amount you want to convert, and then moving those funds into that Roth IRA. During periods when the market is down, this can be a great strategy because you can move over stock positions that are experiencing a temporary decline to a Roth account and pay less in taxes than if the stock was at or near an all-time high, and now those funds are growing tax free. As an example, let's say you own an S&P 500 index fund ETF in a traditional IRA, and a bear market occurs, and the fund drops -20% within the account. If you did the conversion when the S&P 500 ETF was down -20%, you inherently would be paying less in taxes than if the account was at an all-time high.

The final tax-free option I am going to discuss is known as Roth 401k contributions. Roth IRAs have an income limit for who is eligible to put funds into a Roth IRA as a contribution. For 2023, the limit for how much you can earn per year to be eligible to contribute into a Roth IRA is $153,000 if you are single or $228,000 if you file jointly with a spouse. However, Roth 401ks do not have an income limit. That means you can earn $500,000 dollars a year and contribute the maximum annual amount into a Roth 401k (up to $30,000 if you are 50 years and older for 2023). Of course, you would still need to pay the taxes upfront so keep in mind that your monthly take-home amount will be less than with a traditional 401k contribution.

Explore these options if you want to plan ahead for retirement and tax purposes, but as always, please consult your fiduciary advisor or tax advisor before implementing any of these strategies. Even a small increase in your tax situation can have a big impact on whether these strategies are appropriate for you.

The information in this article is solely informational and is not intended to be legal or tax advice. Please consult your tax advisor before implementing anything discussed in this article.

For important disclosures, please visit: clarkgroupam.com/disclosure