When it comes to retirement accounts, what if there was a way to have your cake and eat it too? Instead of the decision to pay taxes now vs. later, what if “never” was an option? If not never, maybe there are scenarios where the taxes are drastically reduced.
Most of the discussion around preferred retirement accounts (Pre-Tax vs. Roth) centers around your current and future tax rates. Though this makes sense in theory, it doesn’t always make sense in real-life.
The reason we need to approach this problem differently is that we’re dealing with different generations than the old financial textbooks.
If the older generations worked at the same job for 40 years with annual 3-4% raises, followed by a “hard stop” into retirement, then approaching retirement funding in a more traditional sense is likely the way to go.
However, millennials, Gen Z, and Gen X have a different path when it comes to a career path. This path involves things like early-retirement, sabbaticals, founding a startup, or going to grad school.
What those things have in common is this: years with little to no income. And years with little income usually mean there is a major tax planning opportunity.
That main tax planning opportunity we’ll discuss in this piece is a Roth Conversion.
In a traditional scenario, you’re putting money into your pre-tax 401(k) and that money stays there until you withdraw it in retirement. You pay taxes on the withdrawal.
Roth IRA contributions on the other hand do not go in tax-free, but they grow tax-free and come out tax-free.
In summary, pre-tax accounts are better at the time of contributions but Roth accounts feel a lot better when you start to distribute the funds.
The issue is: moving funds from pre-tax accounts and into your Roth can feel like the equivalent of crossing a rushing river. You’re waiting for the right time, but it never comes. It could be painful, and even dangerous.
As financial planners, we agree – crossing that river can be treacherous.
However, when we encounter these low (or no) income years it is the equivalent of the river current coming to a crawl. Suddenly there is calm water.
This is the time to cross.
If you add money to a pre-tax account while in the 24% bracket, and distribute it during retirement while also in the 24% tax bracket, then there wasn’t any tax savings.
However, if you add money to a pre-tax account while in the 24% bracket and convert it during a low-income year while in the 10% tax bracket, then there is a massive 14% tax savings.
In addition to the tax arbitrage in this scenario, there are other benefits.
With a Roth conversion, the funds are accessible after 5-years (principal only). You will likely want to keep the funds in the account to continue growing tax-free, but they’re accessible in case you need them. This differs from pre-tax accounts which are essentially “off-limits” until age 59.5.
Again, crossing the Roth conversion river can be treacherous, but if it is done properly and at the right time, the view from the other side can be magnificent.
If you’re trying to decide which account type makes the most sense for you, most of the guidance out there revolves around this question: Which tax rate is higher – your current rate or your expected rate at retirement?
Though that’s a fine question, it’s also worth answering this question: Is it likely that I will have low or no-income years (early-retirement, sabbaticals, founding a startup, grad school, etc.) between now and age 70?
(Age 70 is a key age as Social Security income will have started, and required IRA/401(k) distributions are right around the corner, usually boosting one’s income and tax bracket.)
For many, this second question is both more important, and easier to answer. Nobody can predict tax rates 30 years out, but you may have a decent idea about the next decade or two of your life.
For some people, the hedging opportunity in this decision may be the real kicker.
If you believed that at some point you’d have low or no-income years, but it did not happen, what is the drawback?
In a sense, it’s a win-win scenario. If you ended up being in a high tax bracket from age 22 to 70, and never reached the calm water opportunity to perform a Roth conversion, then you are likely in great financial shape.
The biggest drawback of not experiencing any low-income years is you had 48 high income years! Not a bad consolation prize.