I explain why even though Roth IRAs require more after-tax contributions up front, the benefits seem to outlast those of the Traditional IRA and Pre-Tax 401k during retirement age.
If you’re interested in learning about how to win at retirement investment accounts, check out my free detailed PDF guide on my Resources page.
IRA = Individual Retirement Account, available in the US. I think these tax-advantaged accounts are very useful to save on taxes, whether you’re contributing pre-tax or after-tax money.
The 401k is usually available at your job from your employer, and often there’s an employer match where if you contribute a certain minimum, you get the equivalent match in contributions from the employer. So in a 1:1 match and you put in $3,000, your employer matches that to $3,000, giving you a total contribution of $6,000! No wonder people call the match “free money”!
While Traditional IRAs can have both pre-tax and after-tax contributions, for the sake of simplicity, I consider these to be pre-tax because you can usually get a tax break even if you contribute after-tax contributions to the regular IRA. With a Roth IRA, you only contribute after-tax money.
Not too long ago, I had a revelation of why I realized Roth IRAs would end up being superior to regular IRAs and both pre-tax 401k and Roth 401k (IMHO) — it’s because of the IRS’s Required Minimum Distribution (RMD) rule, which doesn’t apply to Roth IRAs!
The RMD rule changed the age from 70.5 to 72 effective in the year 2020. This means that people are required to take out a minimum amount of money called a distribution from their IRAs/401ks when they turn 72 AND pay ordinary income tax on that amount each year. I explain how I arrived at this conclusion in a detailed spreadsheet example outlining my calculations and assumptions.
The common wisdom generally makes sense while you’re still working in that it’s more ideal to invest in Roth IRA when you’re in a lower income tax bracket while contributing to a pre-tax 401k or IRA when you’re in a higher income tax bracket. Honestly, I think most of us need to invest in both types of accounts because we’re going to need a serious nest egg to survive during retirement someday.
The great benefit of Roth IRAs is you get to grow and invest your contributions without more taxes and then you get to have tax-free withdrawals during retirement. However, there are income limits at which you can no longer contribute to a Roth IRA. The regular IRA doesn’t have this restriction, and fortunately can be rolled into a Roth IRA via backdoor conversion.
Starting at age 72, your distributions are progressively taxed more every year per the IRS’s Lifetime Expectancy Factor from its Uniform Lifetime Table. This assumes you’re also collecting social security income, assuming it still exists 50 years from now.
I was lucky that my older cousins explained the benefits of a Roth IRA to me, so when I turned 18 I opened my first Roth IRA and have been a fan ever since. I’ve also been fortunate to have employers that provide 401ks and the match.
I used to struggle with contributing either pre-tax or after-tax money to my 401k, and initially I thought Roth 401k was better, but then I realized it took a lot out of my paycheck. So then I foolishly thought I could just invest more of my net income in a fully taxable account and only contribute the minimum pre-tax to get my employer’s match. Then I ran into short term capital gains (eg 22%) and long term capital gains taxes (15% for most people). And then I finally came back full circle to Roth 401k.
Roth IRA is the ultimate definition of delayed gratification where I think the anticipated tax savings when I’m in my 70s and up will be worth it. This allows for the Roth to keep compounding and for us to live on a more modest amount of income rather than being forced to use the money because of RMDs.
Now, I like to max out my Roth IRA and Roth 401k, as much as I can. All roads lead to the Roth IRA with the ultimate investing freedom of asset choice and avoids RMD at age 72!
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