The more you make, the more you need to save to have a chance of maintaining your lifestyle in retirement. Your savings rate is likely the number one factor in your ability to achieve your goals. Not market returns, not the economy.
Higher income earners often don’t increase their savings rate as their income goes up. They spend more and more. Then they get to retirement without enough saved to maintain the spending level they’ve become accustomed to.
Boost your savings rate
One sure way to increase your savings rate? Make after-tax contributions to a Roth IRA or 401(k) instead of pretax contributions to a traditional IRA or 401(k).
The standard way of looking at the traditional vs. Roth analysis is to assume that if you make pretax contributions to a traditional IRA or 401(k), you then deposit the tax savings into an investment account. Who does that? Almost no one.
Read: The money in your 410(k) and IRA doesn’t belong entirely to you
Which means for most people, simply shifting some of your contributions to a Roth will increase your savings rate. And increasing your savings rate has a huge impact on the likelihood of achieving your goals.
“But wait,” you say, “I make too much to contribute to a Roth.” That may not be true.
No income limitations for Roth 401(k)/403(b)
Many 401(k) plans and 403(b) plans allow Roth contributions, and unlike the IRA, no income limitation applies to Roth contributions made through your employer plan.
That’s right. Regardless of how much you make, if your employer allows Roth contributions, in 2019 you can put up to $19,000 in the Roth each year (or up to $25,000 for those age 50 and older). And most plans allow contributions to both account types as long as you don’t exceed that total dollar limit; for example, you can put half your salary deferrals into the Roth and half into pretax.
There are also no income limitations on doing Roth conversions. No matter how much you make, you can choose to convert a portion of a traditional IRA to a Roth. You’ll pay taxes on the amount you convert — then once it is in the Roth, it grows tax-free.
Read: The Roth strategy we wish we’d built for early retirement
For most taxpayers, conversions are best done in years where your income is lower — perhaps a year where you are between jobs or the year after you retire. You can convert small amounts each year, rather than converting it all at once.
Too many high-income earners are not aware that they can contribute to a Roth through an employer plan and that they can convert assets to a Roth, regardless of their income.
Why is this so important? Not only do Roth contributions potentially increase your savings rate, they also have hidden tax benefits when it comes time to draw on them.
Withdrawals have hidden tax benefits
Formulas drive taxes. Once retired, certain types of income will impact items beyond your marginal rate; things like your capital gains and qualified dividend tax rate, the amount of your Social Security that is taxed, the premium you pay for Medicare Part B & D, the Net Investment Income Tax, and whether you qualify for the health care premium tax credit.
When you have a pile of money in pretax accounts, every dollar you withdraw goes into these formulas, and can cause you to pay more tax or premiums in other areas. Roth withdrawals don’t count in these tax formulas. Most Roth vs. traditional calculators look only at your marginal rate. They often miss these other factors in the analysis.
When you get to retirement with a balance of pretax and tax-free buckets to draw from, you have more flexibility. In years where you have higher spending, you can draw from the Roth, so you don’t cross into a higher marginal rate. In years where spending is low, it can come from the pretax pot. And you can balance out withdrawals to minimize the impact on many of the other tax formulas.
Also, at retirement, Roth contributions in your 401(k) or 403(b) can be rolled over to a Roth IRA, where no required minimum distributions apply. Contrast that with funds in pretax buckets, where you are required to withdraw and pay tax on specified amounts each year from age 70 ½ on, which limits the tax-planning options at that stage.
If you’ve been thinking you make too much to use the Roth, it may be time to think again.
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