Deciding whether to save in a pretax or Roth account for retirement just got a little easier – at least for people 50 and older.
T. Rowe Price has pinpointed how much late-career workers who want to leave money to heirs should have in tax-deferred savings to justify the switch to Roth contributions. When a person or couple’s assets exceed those thresholds, switching to Roth can lead to an even larger inheritance for their heirs, the company found.
A financial advisor can help you decide between Roth and pretax contributions. Find an advisor today.
“Choosing Roth can result in lower taxes in retirement for the account holder, as well as beneficiaries, which can outweigh higher working-year taxes in many cases,” writes Roger Young, a certified financial planner and thought leadership director at T. Rowe Price. “This can result in after-tax value to beneficiaries increasing by tens of thousands of dollars, without sacrificing spending in retirement.”
Roth vs. Pretax Contributions
The difference between pretax and Roth contributions comes down to how the money is taxed.
Money that’s saved in a traditional IRA or 401(k) is tax-deferred, meaning the funds aren’t taxed when they go into the account. As a result, contributing to a tax-deferred account lowers your taxable income for the year. However, you will owe income taxes on that money – and whatever interest it generates – when you start making withdrawals from the account.
Roth contributions work in the opposite way. Money that’s saved in a Roth IRA or Roth 401(k) gets taxed before going into the account. But once it’s there, the money grows tax-free and can be withdrawn at age 59.5 with no income taxes due. Roth IRAs also aren’t subject to required minimum distributions (RMDs), although RMDs do apply to Roth 401(k)s.
As a result, people who believe they’ll be in a higher tax bracket in retirement often go the tax-deferred route, while higher-income workers who plan on dropping down in tax brackets in retirement stand to benefit from Roth contributions.
When to Consider Switching to Roth Contributions
But tax brackets aren’t the only thing to consider when choosing between Roth and pretax contributions. T. Rowe Price found that Roth savings can be more valuable in an estate plan, because they can lead to larger after-tax inheritances for heirs.
Late-career workers who already have a healthy amount of tax-deferred savings may want to consider switching to Roth contributions if they’re planning to leave assets to non-spouse beneficiaries. To help you decide between Roth and pretax options, the financial services firm has identified “break-even” asset levels for people ages 50, 55 and 60 at different income tiers. Once a person or married couple’s wealth exceeds these break-even points, Roth contributions become preferable to those who want to pass assets on to heirs. Before those thresholds are crossed, however, pretax and Roth strategies produce the same outcomes, T. Rowe Price found.
Married couples who file their taxes jointly benefit from the switch to Roth contributions when they have approximately:
4X to 5X their annual income saved at age 50
5X to 6X their annual income saved at age 55
6.5X to 7.5X their annual income saved at 60
For example, T. Rowe Price found that switching to Roth contributions makes sense for a 60-year-old married couple earning $275,000 per year when they have more than seven times their income ($1.93 million) saved. A 55-year-old couple earning the same amount per year would benefit from switching to Roth contributions once their assets surpass 5 ½-times their income ($1.51 million). Meanwhile, a 50-year-old couple earning $225,000 should consider Roth contributions when they have more than four times their income ($900,000) in savings.
Switching to Roth contributions is generally beneficial for single tax filers with approximately:
4X to 5X their annual income saved at age 50
5X to 7X their annual income saved at age 55
6X to 9X their annual income saved at age 60
For example, a 55-year-old single filer who makes $175,000 per year and wants to leave as much money as possible to an heir should switch to Roth contributions once their pretax savings exceed $1.05 million or six times their income. Likewise, a 50-year-old single who makes $125,000 per year would benefit from switching to Roth contributions once they have more than $562,500 in pretax savings (4.5x their income).
The decision between making pretax or Roth contributions often depends on your projected tax bracket in retirement. However, T. Rowe Price says that late-career workers who may not need their RMDs to cover retirement expenses should consider Roth contributions because they can produce superior after-tax gains for their heirs. The company calculated break-even asset levels to guide your decisions.
Roth IRA Tips
A financial advisor can help you start saving in a Roth IRA. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
The SECURE Act of 2019 made Roth IRAs even more valuable within estate plans. A provision in the law requires those who inherit retirement accounts to draw down the balances within 10 years of inheriting them, rather than spreading those distributions according to their life expectancies. Since Roth distributions aren’t subject to income tax, this provision won’t impact people who inherit Roth IRAs.
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