The Hidden Costs of Overfunding a Roth IRA

Key Takeaways

• Successful people often find themselves in the same tax bracket in retirement, if not higher than they were during their working years.

• Contributing to a Roth account isn't always optimal; it depends on whether your tax rate will be higher or lower in retirement.

• For high earners, traditional pre-tax accounts often provide better returns if their retirement tax rate is lower.

When it comes to saving for retirement, most people think that contributing 100% to a Roth is the best course of action, since the tax benefits are considerable. And in most cases that would be the right decision. But depending on your income, you could be hurting yourself by contributing too much into a Roth.

Let’s say you earn $1 million a year from your work. It wouldn't make sense to contribute to a Roth 401(k) and you’d be making too much to contribute to a Roth IRA. You’d want to defer as much of your income as much as possible since presumably your income tax rate in retirement will be lower than it is now in the highest tax bracket. So, the play is to contribute pre-tax money, not after-tax money like you would with a Roth.

Of course, most people don’t know exactly what their tax rate will be in retirement– or even what the tax brackets will be. Most Americans are in a lower tax bracket once they retire because their income is lower. Makes sense. But many successful professionals and business owners are surprised to find themselves in the same tax bracket, if not higher, in retirement. That is when pensions, Social Security and required minimum distributions (RMDs) from retirement accounts must be taken.

At Novi, this type of tax planning is an area where we spend a lot of time counseling clients. We can then look at what their tax rate is now and try to determine whether it’s better to make pre-tax or after-tax contributions to retirement accounts. This is something that many savers and investors don’t consider. As the chart below shows, if your tax rate during your working years is 22% and your tax rate in retirement is also expected to be 22%, then it doesn't really matter what you do. It will be a wash. However, it would be better to make the Roth contributions just because you'll be getting growth in a vehicle that you can eventually take out tax-free.

Source: Adapted from Vertex data

Let's assume that instead you're in the 22% rate during your working years but expect your tax to decline to 12% in your retirement years, the chart above shows you’d have 11.4% less money in your pocket by going with a Roth option versus a traditional option. That’s right; you're actually hurting yourself by contributing to a Roth in your working years. You would have been better off contributing to a traditional option.

It's a bit of a balancing act figuring out the best way to contribute to your various retirement accounts. If it looks like your pensions, Social Security and RMDs will eventually push you into a higher tax bracket in retirement, you might want to contribute to a Roth instead of a traditional 401(k). There are two reasons for this.  First, you’ll get growth in an account that you will eventually be able to take out tax-free (Roth) as opposed to a vehicle that you’ll have to pay income on (Traditional). Second, you are not required to take minimum distributions from a Roth IRA, but you are required to do so for a Traditional IRA. Therefore, the Roth option will allow this money to continue to grow AND it will not require you to take income if you don’t need it whereas a traditional option and its RMD structure would.

Example 1: A working couple makes $1 million dollars a year. They're saving into their 401k, making pre- tax contributions. They'll also have Social Security and some RMDs which they'll have to start taking at some point. But the majority of their assets are going to be in taxable, non-retirement brokerage accounts, since there’s a limit on how much they can contribute to their 401(k)s every year. Because of the preferential tax treatment of those types of accounts they will most likely have a lower tax rate during retirement.

To make the math easy, let's say 22% is their tax rate during retirement. But when they were earning $1 million during their working years (when making contributions), their tax rate would be around 37%. If they're going to be in the 22% bracket during retirement, that gets them to minus 19.2%, which means they’ll have 19.2% more money if they contribute to a pre-tax 401(k) than they if they contribute to an after-tax Roth. The numbers don’t lie.

Source: Adapted from Vertex data

Example 2: A married couple, both teachers, work in the public-school education system. While their incomes are modest compared to the millionaire couple above, they both earn a generous pension and want to save for retirement outside the pension. They’re in the 12% income tax bracket now, but thanks to the big teachers’ pension, plus Social Security and their retirement savings, they’ll likely see more income in retirement than during their working years. That should push them into the 22% or 24% bracket in their golden years. In this case, we’d recommend making Roth contributions during their working years since that would give them roughly 12% to 16% more money according to the chart.

Conclusion

No one has a crystal ball about what tax rates will be 10, 20, or 30 years into the future. Trying to “time” the tax code is as foolish as trying to time the stock market. So, it pays to work with the knowns you can control and a skilled fiduciary advisor can be a big help. Overfunding Roth IRA

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RYAN A. DUNN, CFP®, is a Wealth Manager at Novi Wealth