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Here is why Roth savings make sense right now

The majority of American workers now saving into a company 401(k) plan for retirement. Within their 401(k) plan most employee contributions are made with pretax dollars and all employer match and profit sharing contributions are made with pretax money.  This is a great way to lower your income tax liability in the years that you are working and making the contributions. However, blindly putting money into a 401(k) plan using pretax dollars can lead to a long term spike in your and your beneficiaries income taxes. The solution to consider now is adding Roth savings, either through a Roth IRA or Roth 401(k), into your savings strategies. This can be done either by contributing or converting your savings.  Here are some reasons to consider that now.

 

1. Required Minimum Distributions can propel you into a higher tax bracket

A Required Minimum Distribution(RMD) is a withdrawal that everyone over the age of 72 are required to take from their pretax retirement savings. The only exception to this is non business owners still working and saving into their company 401(k) plan. The purpose of these distributions is for the IRS to start to collect tax dollars from money that has been tax deferred up to this point.  These withdrawals will add to the amount of taxable income that retirees will have. This number gets added on top of Social Security, pension income, rental income or any part time income one may have in retirement.  From my experience many retirees do not need these withdrawals to live off of.  These withdrawals can also make your Social Security payments taxable.  Roth IRA savings are beneficial to combat these withdrawals because they do not require RMDs.  By having more of your money saved in a Roth IRA vs a pretax IRA this will reduce the amount of your annual RMD.

As you can see from the chart above, once the process of RMD’s start there is a sharp increase that one will pay in taxes on an ongoing basis.  The RMD amounts slowly increase over time as the account balance also increases.  This can lead to spending your remaining years in a higher tax bracket. Another consequence of higher income from the RMD’s is the effect it will have on Social Security payments. Up to 85% of Social Security payments will be taxable if your income is above $44,000 for a couple and $32,000 for individuals in 2020.

 

2. Current tax brackets will sunset in 2026

When we turn the clocks over to the year 2026 the current Tax Cuts and Jobs Act that was passed back in 2017 will sunset and the rate for individuals and couples will revert back to where they were in 2016.  This means the tax brackets for will increase for all Americans.  With the amount of stimulus money that has been give to both individuals and companies it is difficult to image a world where our taxes will be lower than where they sit today.  From a planning perspective this gives us fives years for planning and finding ways to convert or contribute into Roth.

3. Passing money on to beneficiaries 

The SECURE Act that was passed by Congress back in December 2019 had a great deal of impact on retirement savings. One of the biggest changes this act made was on passing pretax IRA accounts onto the next generation.  The act eliminated the stretch provision over the lifetime of the beneficiary.  The benefactor of an Inherited IRA now must liquid the entire account within a 10 year period.  For example if a beneficiary receives a $1,000,000 inherited IRA they now have to take out at least $100,000/year to fully liquidated the account in 10 years. Think of your beneficiaries and the stages in life when they may receive these accounts.  Many of them could be in their highest earning years and this could be a very large tax burden at that time.  The solution to this is also a Roth IRA. Even though the beneficiary will still be required the liquidate the account in 10 years, the withdrawals they will be taking will be income tax free.

The solution for many can be to start converting or contributing to Roth savings both leading up to and in retirement. The advantage of a Roth IRA is that you do not have to take the Required Minimum Distributions.  Also, qualified withdrawals from a Roth IRA are received income tax free which can allow you to stay in a lower tax bracket in retirement.

 

 

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