Ready For Retirement

Is It Possible to Have Too Much in Roth IRAs?

July 18, 2023 James Conole, CFP® Episode 172
Ready For Retirement
Is It Possible to Have Too Much in Roth IRAs?
Show Notes Transcript Chapter Markers

There are a lot of good reasons to put your money into a Roth account. But does it make sense to have all your money in Roth accounts?

The truth is, there is  a point at which it's potentially harmful to continue putting money into Roth accounts. 

James explains the nuances of Roth accounts and tax planning, while answering a listener's question.

Questions Answered:
Is there a point at which you can have too much in a Roth account?
How can you use tax planning in retirement?

0:00 Intro
1:17 Listener question
3:59 Short answer
5:41 Example
8:04 Tax planning
9:10 Eample
11:45 Two questions
14:18 Charitable giving
18:22 Example
20:57 Outro

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Speaker 1:

I think we all wish sometimes that we could wave a magic wand and have all of our investment accounts magically become Roth accounts, where they grow and be distributed tax-free for the rest of our lives. But does it actually make sense to have all our money in Roth accounts? Or even if it's not all of our money, is there a point at which you can have too much in a Roth account? Well, that and more is what we're going to cover on today's episode of Ready for Retirement. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. There's a long list of benefits that come with having your money in a Roth IRA. To name a few, the benefits are tax-free growth of any dollars you put into a Roth, tax-free distributions from those funds. Any distributions aren't counted in Irma surcharge calculations. They aren't counted in provisional income calculations, are not subject to required minimum distributions. There are a lot of good reasons to put money into a Roth IRA or Roth 401K. However, practically speaking, the method by which you would do that is not always beneficial, and what we'll start to see in today's episode is there does come a point at which it's maybe hurting you to continue putting money into Roth accounts. So today's episode is going to be an answer to a listener question, and this question comes from Aaron. Aaron asks this. He says I'd like to get your thoughts on diversification versus Roth accounts for young savers. I'm 36 years old and my wife is the same age and until now we've been maximizing savings in Roth accounts. Based upon the long-term growth rising at our age and historically low tax rates until 2026 were both in the 24% tax bracket we have expectations of higher earnings in the future. Today we have about $600,000 in Roth accounts and $70,000 in tax deferred accounts. All of our qualified plan contributions are Roth via backdoor Roth IRAs and my 401K. We do in-plan Roth conversions of any company matches to the extent allowed and we put the rest of our savings in a taxable brokerage account. The conventional wisdom I've heard is that for young savers, roth is the best option, especially with the currently historic low tax rates. How should I think about the downsides of being concentrated in a Roth with relatively little tax deferred savings? A couple of things that come to mind for me are number one more tax deferred would allow us to save more and non-qualified accounts that are more liquid before retirement age. And number two, tax deferred is the best option for charitable gifts during retirement age, since it's never taxed. Thank you so much, aaron. Well, aaron, very good question. I think there is a lot of wisdom even in this question of we all get the benefits of Roth accounts Many of them I just listed but there's a price you pay for those benefits. That price you pay is for going tax benefits today, for going tax deductions today in exchange for that. So how do we balance that out, apart from just our lower tax bracket today or in the future? I guess that's one consideration, but what are the other things we should be looking at, and we're going to explore that in today's episode. Before jumping in, I'd like to highlight the review of the week, and this comes from a username, frustratedalot, and Frustratedalot gives the show Five Stars and says James has an awesome job with topics that are relevant and focused on different topics. Each week. He explains the topic using examples that make it easy to understand. I look forward to hearing what topic he's going to cover each week. Thank you, james, for being a great resource to all of us that are going through the retirement process. Thank you very much for leaving that review. Thank you to all of you who are leaving reviews. Time to see more and more people tuning in each week and getting great material that they can use to apply to their situation and get a better retirement and ultimately, as we talk about, get the most life out of their money. So thank you for those of you leaving reviews. If you've not already done so, please take a couple seconds and hit a Five Star review if this show has been helpful to you. With that, let's get into the episode, and right off the bat, I'll start with this. The short answer is it does not often make sense to only do Roth contributions forever. Now, that's not always the case, but most of the time it is, and that's because you probably want some pretty tax accounts for a variety of different reasons. Here's an example to illustrate why. Let's assume that you are a married couple and you're retired and you have a million dollars, and that million dollars is just in a Roth IRA. So you, your spouse, you've just put money into Roth accounts, you've prioritized that, you've sacrificed tax deductions, you get to retirement with a million bucks and it's really nice to have that million dollars all in a Roth IRA. Well, for 2023, the standard deduction for a couple that's married finally and jointly in their taxes is $27,700. So let's assume you're that couple. You have a million dollars on a Roth IRA and you're pulling out 4% per year to live on and that's your only income source. So back out social security or pension or anything. For a second, just use a real simple example. Well, that $40,000 is completely tax free. Remember the benefits of a Roth is, at some point when you start living on it, you don't pay any taxes on the withdrawal, so that's a really wonderful benefit. However, keep in mind, to get to that million dollars in your Roth account, you paid a price for that and that price was for going the tax savings in your working years that you could have received from doing a pre-tax contribution or a traditional contribution to a 401k IRA. Hey everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Let's look at another example. So keep that in mind and I'm going to compare that now to this. That very same couple in an alternate universe still has that million dollars in their portfolio, but now 65% of it is pre-tax and 35% of it is Roth. This couple still wants to live on $40,000 per year and let's assume that of that $40,000 that they pull out, it's proportionate between pre-tax and Roth. So 65 cents of every dollar is pre-tax, aka taxable, and 35 cents of every dollar is tax-free because it's coming from their Roth. Well, if they did that and if they pulled out $40,000, $26,000 of that would be pre-tax, so subject to taxes In $14,000 would be tax-free because it comes from their Roth IRA. So if you just look at these two scenarios and quickly compare the two, it seems as if in the second example that couple would be paying more taxes than the first example, because the first example the couple was paying nothing in taxes. Well, here's the thing I mentioned that for 2023, there's a standard deduction that you can take on your tax return and that standard deduction is $27,700. In that second example, we have the couple with a million bucks where about two-thirds is pre-tax and one-third is Roth. Well, the first $26,000 that they pull out of their portfolio. That's taxable. It's actually not taxable because the standard deduction offsets all of that. So standard deduction eliminates the tax on their pre-tax withdrawal and then the additional $14,000 that comes out as Roth, that is tax-free. So what you see here in both examples, both of these couples has a tax-free income this year. The difference is one of these couples took some tax deductions along the way During their working years. They were taking advantage of tax deductions by putting money into a traditional IRA or traditional 401k, whereas the other couple, probably with the right thinking, was saying let's just do Roth accounts to minimize our taxes in the future. But what you can start to see is that's not necessarily the case and at some point it does start to cost you to only make Roth contributions. Now, admittedly, this is a very basic analysis. It doesn't factor in any social security or pension or dividends or interest or other income sources that the standard deduction could also be applied against. But the bottom line is oftentimes being all Roth, or even too much Roth can cost you more than it hurts you. So in today's episode, what I want to do is I want to talk about tax planning in retirement or things you can do today in your working years to think about tax planning in retirement, and how do you prioritize Roth contributions versus other types of contributions to make the most of your total portfolio going into the future? And there's three core areas in which this applies. So, as you're thinking about where you are today in your working years, do you do Roth contributions? Do you do pre-tax contributions? There's three distinct things I want to point out to you, not that this is a comprehensive or an exhaustive list, but three of the first things that I would point out to say based upon your responses to this. This is what might determine the course of action with regards to pre-tax versus Roth accounts, the first of which is to what extent can you do tax planning at retirement? And that's very broad. But what I mean is this let's assume you are a year away from retirement and you're in a 24% tax bracket today, but when you retire you'll immediately drop down into the 12% tax bracket. But would it make much sense to contribute to a Roth 401K in that year versus, say, a traditional 401K? Let's look at an example. What if you had $10,000 you were going to contribute? Well, if you contribute that $10,000 to a pre-tax 401K, then that saves you $2,400 in federal taxes. So you make that contribution, you save $2,400 in taxes, and then you retire, and when you retire, let's assume again that you're in that 12% tax bracket. Well, what if you immediately converted the $10,000 that you put into your 401K into your Roth IRA at that point? Well, if you did that now, all the money ends up in the Roth account and it costs you $1,200 to do so. So what you've done is you've accomplished the goal of giving the $10,000 into a Roth account assuming, of course, that's your goal but you've done it by paying half the amount you would have otherwise paid in taxes, instead of putting that $10,000 directly into your Roth, and it would have cost you $2,400 to do so, meaning the tax savings you would have foregone to do that. You put it into the pre-tax account first, and that saves you $2,400, then you later convert it to a Roth and that only costs you $1,200 at the federal level, and the difference is $1,200 in savings. So this is the concept of tax planning. There's not necessarily a universal answer to should you do a pre-tax contribution or should you do a Roth contribution Instead. What you should be looking at is you probably have a good understanding of what tax bracket you're in today, and if you don't know, you can pretty quickly find out by understanding what your income is and what your deductions are. You can find out what tax bracket you're in today, but that's only half the equation. You need to know your tax bracket today, but then ideally, you need to know what tax bracket will you be in retirement. That's where it can get a little more tricky, because you have to look at what's going to be the compounded growth on your assets. What income sources are you going to have at that time? What will your expenses be, or your desired expenses at least? What will the impact of required minimum distributions be? Where will tax rates be? And that's probably the biggest unknown for most people. But to do tax planning right, you have to have a clear idea of where do you stand today and where are you likely to be in the future. Once you have a general sense of what that's going to look like, then what you try to do is you try to prioritize pre-tax deductions where taxable income at least overall tax liability is going to be highest, and then you want to pay taxes or do Roth conversions or things like that in years where income is likely to be lowest. Now to follow up on the example I gave of what if you're in the 24% tax bracket today but you're projected to be in the 12% tax bracket immediately upon retirement? That's an overly simplistic example. There would really be two follow on questions you'd have to ask based upon that example that I provided. Number one is how much quote unquote room do you have in that 12% bracket? Here's what I mean by that For 2023, if you're married, finally, and jointly, if your taxable income is between $22,000 and $89,450, then your tax bracket is 12% or your marginal tax bracket is 12%. So if you're looking at that and you are at $30,000 of taxable income and remember, your taxable income is your adjusted gross income minus deductions so if your taxable income is, say, $30,000, then you still have $59,450 until you move up into the 22% tax bracket. So that's a good amount of space. It allows for that much in conversions or the realization of some other type of income until you start to push into another tax bracket. Versus if you're already at $89,000 of taxable income, then yes, you're in the 12% bracket, but you only have $450 to go until you bump up into the 22% tax bracket. So, going back to my example of you're in the 24% tax bracket today, while you're working, and you're going to be in the 12% bracket when you retire. The first question is well, how much room do you actually have in that 12% bracket? Do you have a whole lot of room because you're at the bottom end of that range, that range being the 12% tax bracket threshold or do you not have much room and you're pretty much in the 22% tax bracket because any additional conversions or income you realize is going to be taxed at the higher rate? The second question is a follow-up to that is is that room sufficient to convert your desired amount from your traditional IRA to your Roth IRA? So say, you have some room to do some conversions. Well, that's good, that's step one. But really the question you want to compare that to is how much do you need to be converting to minimize whatever your future tax liability is going to be from required distributions or whatever the case your tax strategy might be calling for? So, for example, do you only need to do $25,000 per year of conversions for your tax plan? Well, if so, there's a good chance that conversion amount can fit within the 12% bracket versus, do you need to do $250,000 per year of conversions? Well, there's zero chance that's going to fit into the 12% bracket unless you have some really serious deductions on the deduction side to offset that income. So I provide that example at the beginning, but that example is very simplistic and there are some nuances to it. But the first thing you need to consider is what is your overall tax plan call for? The other thing that I would consider when you're looking at Roth versus pre-tax and Aaron smartly alluded to this is charitable giving. If you do a lot of charitable giving, then it likely makes sense to do fewer Roth conversions than you otherwise would have, and not just fewer Roth conversions but maybe even less in total Roth contributions. And here's why I say that Roth IRAs are great, roth conversions are great, but they cost money. So anytime you make a Roth contribution, anytime you do a Roth conversion, it's costing you something, and that cost is either an opportunity cost in terms of Roth contribution the opportunity costs is the tax savings you're foregoing or an Roth conversion. The cost is very direct cost. It's the cost of taxes that you have to pay to fund the tax bill on that Roth conversion. So Roth contributions, roth conversions. They can save you a huge amount of money, but there is that upfront investment to doing them. Well, there's something called a qualified charitable distribution, and a qualified charitable distribution is a way to give money directly from an IRA to a charity of your choice. Now, the qualified charitable distribution, you can't actually do this until age 70 and a half, but once you reach age 70 and a half, you and your spouse each separately, can give up to $100,000. That'll be adjusted for inflation From your traditional IRA to a charity and when you do that it doesn't cost you any taxes. The funds go directly to the charity, so they never hit your bank account and you never pay taxes on them. So, in a way, I know you might be saying what on earth does this have to do with my decision to do a Roth contribution or not? Well, a qualified charitable distribution kind of allows you to view your IRA as being similar to a donor-advised fund in many ways. So, if you're not familiar, a donor-advised fund is an account that allows you to get a deduction for putting money into it. So you open a donor-advised fund. It's a separate giving fund. You put money into it. Now, when you put money into it that money can be invested in gross tax-free. Then when you choose to do so, you can make gifts to a charity of your choice and there's no impact to you for doing so no tax impact to you and of course, the charity does not pay taxes either. So that's what a donor-advised fund is, but with an IRA, if you're going to implement qualified charitable distributions, it replicates the benefits not fully, but in many ways it replicates the benefits of that donor-advised fund because you also get a deduction for putting money into an IRA or 401K. You also are able to invest your money when it's in an IRA or 401K. You also get tax-deferred growth inside of an IRA or 401K and you also can make gifts to the charity of your choice and there's no impact to you from a tax standpoint once you've reached age 70 and a half and of course there are some limits on how much you can actually gift. But the reason I mention this is if giving is a part of what you do, if you're giving a specific dollar amount or percentage of your income, keep in mind that's probably a reason to maybe think more so towards pre-tax contributions than you otherwise would have if charitable giving isn't something that you're doing a whole lot of. I'm not saying you shouldn't do Roth contributions. And I'm not saying you shouldn't do Roth conversions. I'm just saying that you maybe would do less of them than you otherwise would have had charitable giving not been part of something that you want to do. So if you're going to do a lot of giving, then it's not bad to have a large pre-tax balance. That's one of the important nuances to consider. So often we want to know who should do a Roth conversion and who shouldn't, and how much should I convert this year versus how much next year, and what if this, what if that? Well, there's so many different nuances, and even something as seemingly irrelevant as charitable giving actually plays a really important role in terms of the analysis that you should do when determining what's best for you. So charitable giving is an important component of that decision-making process. And then, finally, the third consideration and I'm mentioning this specifically because Aaron says he's younger, he's 36, he and his spouse. The timing of contributions really matters. Here's an example that shows why. Let's assume that from age 20 to 60, you invest $10,000 every single year and that money grows at 8% per year. Well, if you did that, you would have $2.6 million by the time that you turn 60. But what if you did half Roth contributions and half pre-tax contributions? Does that mean you'd have exactly $1.3 million in your Roth account and $1.3 million in your pre-tax account? Possibly, but it depends upon timing. For example, let's assume that from age 20 to 40, you contribute solely to Roth accounts so still $10,000 per year, but solely to Roth accounts and from age 40 to 60, you do pre-tax accounts so still $10,000 per year, but it's going to your traditional 401k, your part to a traditional IRA and part to a 401k. Well, here's how that math then plays out by age 60. You still have the full $2.6 million in your portfolio, but 2,130,000 of that is in a Roth account and only 470,000 that is in a pre-tax account. So notice, the dollar amounts at the end did not change, but what you see here is it significantly tilted and skewed towards a Roth balance. And Aaron again wisely or smartly on his end, alluded to this of hey, when we're younger, do we take more advantage of Roth accounts and then maybe shift our savings to pre-tax accounts. So what you can see in this very basic example is there's a lot of merit to that type of thinking Of the more you can put money into Roth accounts earlier, the better you're going to be, and even if you're not 30 or 20 or 40, even maybe you're 60, and say, well geez, does that mean I don't want to do Roth contributions? No, that does not mean that. What it does mean, though, is the benefit of those Roth contributions if you're 60 years old isn't going to happen by the time you're 61 or 62 or 65. Ideally, you're investing that money today, but maybe not using it for 10, 15, 20 plus years. So benefits from Roth IRAs don't come immediately, because you don't get any tax deduction. The benefit comes as you get tax-free growth and, of course, the longer you leave those Roth accounts alone, the more tax-free growth there will be. So understanding not just your tax brackets and timing and all this different stuff, but also understanding when should I be putting money into Roth accounts versus pre-tax accounts, is an important consideration as well. So I hope that this conversation is helpful, because, as much as I love Roth accounts, and if we can wave magic wand, like I said at the beginning, and miraculously make all of our accounts Roth accounts, well, there's no downside to that, really, but, practically speaking, the downside of getting there without a magic wand tends to mean you pay more in taxes than you need to. So having the right balance between pre-tax accounts, roth accounts and even non-retirement accounts is often what's best, but customizing that to your specific situation. So that is it for today, aaron. Thank you so much for that question. Thank you to everyone who's listening. For those of you leaving reviews, if you've not already done so, be sure to check out our YouTube page. It's under Root Financial where you can get this episode as well as other weekly episodes of other retirement concepts. Thank you for listening and I'll see you all next time. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the technique side discuss this podcast then go to rootfinancialpartnerscom and click Start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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