Over the past few weeks I’ve replied to numerous comments and questions, loosely paraphrased as:
“I’ve read that you aren’t a big fan of Roth accounts, but in your post about not paying taxes for 5 years you show how you routinely contribute to Roths. Isn’t that a bit hypocritical?
Maybe.
It’s a totally fair question. Let’s find out.
Saving for Early Retirement
To save for early retirement we need to accumulate assets worth at least 25x our desired annual cost of living. Some of those assets will be in a Traditional 401k/IRA, some will be in a taxable brokerage account, and some may be in a Roth account. (We were about 25/75/0 pre-tax/taxable/post-tax, afair.)
There are more complicated strategies, but often people will save enough in a brokerage account to get to age 59.5 and then tap into the 401k/IRA. This was my guiding principle. As long as you have those core assets in place, then contributing a bit to a Roth is certainly reasonable if it floats your boat.
When people say “I know you aren’t a big fan of Roth accounts” they are usually referring to this post in which I explain why we didn’t contribute.
But I think this perception misses some key thinking. I like the phrase, “To a man with a hammer every problem looks like a nail.”
Based on the large number of mass market personal finance articles on Roths, we could easily restate that as, “To an aspiring retiree with a Roth account….”
A Roth type retirement account is a tool with pros and cons, just like every tool of every kind. It’s the law of the instrument. Each has a purpose and a specific use case where it is uniquely situated. A wrench is terrible at putting a nail into a piece of wood, but perfect for tightening a nut on a bicycle.
So let’s look at the pros & cons of Roths…
Pros
All gains are tax free
Can withdraw contributions at any time with no restrictions or tax implications (take your money back)
Qualified withdrawals don’t impact MAGI (important for ACA.)
Cons
No tax deduction for contributions
Losses are disregarded (can’t claim a loss to offset other income)
Income with foreign tax withholding can’t claim the FTC
Earnings can’t be touched without penalty and taxes until age 59.5
Roth “Pros” and Cons
The 2 most oft cited pros of the Roth type accounts for early retirement are:
- All gains are tax free
- Can withdraw contributions at any time
All gains being tax free is a wonderful thing. I love it. (A lot!) But I also get the same benefit from my taxable brokerage account.
(Early retirees in a State with an income tax and/or enrolled in ACA health insurance would not have the same benefit.)
Over the past 5 years we have received $158,144 in dividends and realized long term capital gains of $147,207. That is $305,351 worth of taxable income, all with a $0 tax bill (actually, negative $4.)
Now you might say, “Yeah, but the Roth has the same $0 tax bill, automatically.” And you would be right. But I can use all of these dollars now, not after age 59.5. The value of access to earnings diminishes with time – it is more important to a 35 year old than a 55 year old.
“But you can withdraw contributions at any time!”
Indeed.
Let’s explore a scenario where somebody contributes $5500 to a Roth account every year from Age 21 until they retire at age 35. Assuming no withdrawals, with 7% real CAGR it will be worth about $800k at age 59.5. Nice!
Contribution purchasing power decreases with time. Access to earnings is more important to the youngest retirees (30s vs 50s)
15 years’ worth of contributions total $82,500, which may or may not be a significant amount in terms of our 25x annual cost of living goal. But inflation has been insidiously working even as we accumulated… at age 35 purchasing power is only $65k. At 45 it is $48k. The remaining $250k of real account value and growth thereof is inaccessible for another 15 years. (Is this a con?) But I can access this at my leisure, since it is all in my brokerage account.
So withdrawing contributions is nice, I guess, but why go to all the trouble of contributing if you are just going to take the $ out right away?
The other main con is inability to claim the Foreign Tax Credit on International funds held in a Roth (or Traditional) IRA. (This could be avoided by only holding these assets in a taxable account… if you have one big enough.)
A married couple can potentially claim up to $600 in FTC per year. This can offset an additional $6,000 in Roth IRA conversion, the process of moving funds from a Traditional IRA to a Roth. That’s a nice 25% boost over the Standard Deduction.
The Real Pro
So at this point you might be thinking…. after stating the pros of Roths aren’t really pros, and dismissing the cons, why am I contributing to Roth accounts again?
My primary concern about early retirement is running out of money. Everything I do for tax efficiency and tax minimization results in more dollars working for us for the long term, to insure we are fiscally secure (and also because it is good fun.) If we needed to fund a big purchase from a Traditional or Roth account before age 59.5, it would result in a punishing tax burden – large withdrawals are not tax efficient. With most of our funds in a taxable brokerage account this can never happen – there are no restrictions on accessing our funds.
My secondary concern about early retirement is running out of money due to excessively high cost of health insurance and health care. If we were to one day return to the US as our forever home, we would enroll in an ACA health insurance plan. Costs are fairly reasonable for incomes below 400% FPL, but the premium subsidy cliff can be massive… looking at this recently I saw premiums increase from ~$300/month to $1,000/month for earning an extra dollar.
This is annoying but manageable if planned for. But… by age 60 our unsubsidized premiums TRIPLE! Older people pay more for insurance than younger people, it seems.
Which leads me to the 3rd Roth pro on my list:
Qualified withdrawals don’t impact MAGI.
At age 59.5 we have unrestricted access to ALL of the funds in any Traditional or Roth accounts. Withdrawals from Roths have zero impact to our MAGI (modified adjusted gross income) upon which ACA subsidies are based.
Sufficient Roth funds between age 59.5 and Medicare enrollment can virtually guarantee we never go over the ACA subsidy cliff during these, the most expensive health insurance years. During the few years prior we could access Roth contributions, if necessary, devastated as they are by inflation.
Roth Hypocrisy
Over the past several years, I’ve been converting our Traditional IRA to Roth and contributing to Roth accounts, all at 0% tax. Tax free in, tax free out.
Roth accounts have a great “Pro” in that all qualified withdrawals are 100% tax free, and most importantly don’t impact MAGI for tax purposes. This is important for the ACA, as it can virtually guarantee not falling off the ACA subsidy cliff. It is particularly important in the later years (60+), when unsubsidized premiums soar. Conveniently, this is also the time all access restrictions to Roth accounts are lifted.
The funds in our Roth solely from converting our Traditional IRA funds would have been more than sufficient to fulfill our MAGI optimized withdrawals pre-Medicare, but since we already have sufficiently large brokerage accounts I make additional Roth contributions. It can be a helpful leg of a pre-tax/post-tax/taxable 3-legged stool.
I certainly could have contributed to Roths while accumulating, although it wouldn’t have helped or hindered our efforts.
Hopefully this helps explain why we are contributing to Roths now, while choosing to avoid contributing to Roths while accumulating.
Do you contribute to a Roth?
Since the dividend yield of VXUS is almost double that of VTI isn’t it still better to shield that dividend in a tax advantaged account despite the FTC?
I want the dividends. I spend them daily.
Touche :) still in the accumulation phase
There is a small cost to not contributing to Roths during the accumulation phase. If income exceeds the tax free threshold then qualified dividends are taxed at 15% and non-qualified dividends at your marginal rate. Ironically, it is possible for non-qualified dividends to be taxed at 12% while qualified divs are taxed at 15%…
For the $5500/year we are talking about on funds with ~2% yield this is <$20/year.To date the FTC has exceeded our cost on the NQDs. The big disparity between yield on VTI and VXUS is new... they've been close to parity for a few years but international stocks are down relative to US stocks so the spread has grown.
Lol, what happened to your thinking from the “Fewer Dividends, Please” article…….
I like dividends. I just don’t want them growing way faster than inflation.
While working we focused strictly on deductible IRAs and 401ks. Every year we scored around $15000 in tax savings thanks to maxing out those accounts.
Now that we’re retired, and in a situation similar to you, we’ve taken a 180 degree turn. Since we have a little blog income and other 1099 income, we max out the Roths x2 and I max my solo Roth 401k as well. Plus I do a few thousand of Roth conversions to get my income up to the level where I still pay zero federal income tax. Adding to Roth space in early retirement is a freebie!
Are you losing ACA subsidies on your Roth conversions?
Yes and no. We pay almost nothing for ACA coverage as it is. But technically we could save a few hundred per year in ACA subsidies by foregoing the Roth Conversions.
But we’re in a non-medicaid expansion state where if your income is too low you don’t qualify for ANY subsidies. So we also need to do Roth conversions and Roth contributions (instead of traditional contributions) to keep our incomes HIGH enough to qualify for ACA subidies (as perverse as that logic is…)
I understand disliking the logic but it’s because the laws are designed for those who are working. The assumption is that if you have enough to retire and not work then you should be a bazillionaire who spends 50k a day. The idea of a frugal retiree living smartly and well off of a decade or two of work just doesn’t enter the thought processes of those who make the rules.
Hi GCC – Yes, I do contribute the max to Roth IRA account every year after I fully fund my federal non-Roth 401K (TSP). But, that is due to my life situation. I will be retiring at in approximately 5 years at 56/6 months with a federal pension and when I do, will only 3 years away from accessing the contributions in my Roth IRA account. I have been trying to figure out the math how to as a single person, to minimize the taxes I would pay post retirement – considering I will be getting the pension. My point of view is that this is a “good” problem, but not sure if I can be at 0% tax post retirement. Thanks for another stop and made me think post.
With a pension it may not be possible to pay zero taxes. Personally I would rather have a pension and pay taxes than no pension at all. You probably also get good health insurance that isn’t MAGI dependent, so maybe some opportunity to cap gain harvest or Roth convert at low-ish tax rates to minimize RMD down the road.
Here you have hit the nail on the head. I believe that the federally guaranteed health care (at employee rates) for life is, in fact, the bigger deal than the pension itself (though I shan’t complain about receiving a pension). As federal employees, with the RMDs looming, we have now switched to contributing as much as possible to Roth TSP and IRA. With one child in college and another beginning college next year, we just need to ensure our joint income remains under $160k in order to claim the full AOTC. Upon retirement we hope to convert a large amount from traditional TSP / IRA to Roth, but we’ll probably run out of years before we run out of tax-free conversion. As you say, it’s better to have a pension AND health insurance, while paying taxes on the former, than no pension at all.
The main reason I contribute to Roth still (after maxing 403(b), etc.), is to shelter the money from state taxes. I pay 0$ federal, but still have a flat ~5% state tax on all dividends in non-sheltered accounts.
It’s good to have some money in all 3 tax buckets. That gives you more flexibility.
We contribute to Roth for that reason. A big percentage of our asset is in the pretax bucket. Once we start withdrawing from that, the Roth will become more useful. State tax really bites. We need to move…
We looked briefly at Bend as a possible home base. Oregon taxes are ridiculous though
Go to the North side of the border / Washington state. No state income taxes. Wouldn’t want to be there in the winter though. Too much rain and chilly.
Hypothetical question…if you were in your 20’s trying to pursue FI, to account for potential health care expenses prior to age 60, would you consider funding a HSA invested in low cost market based fund first, then moving on to contributing to a Roth IRA? Then once you FI/RE use the HSA to fund your health care premiums/expenses, and if you still have money left over in your HSA, you can roll over to a traditional IRA at 65 years old, correct? Figure you can get the instant deduction now with the HSA contribution and employers sometimes provide a contribution to the employee’s HSA on a yearly basis. So the tax efficient flow would be 401k (to get the full company match), HSA (if there is an employer contribution), Roth IRA, post taxed brokerage account. Thoughts? Thanks
Can you use HSA for healthcare premiums?
See the ordered list of where to contribute in this post.
I would aim to withdraw zero from HSA until absolutely necessary. Big health expenses are coming… best to let those funds grow until then.
I don’t believe you can pay premiums from the HSA.
Actually, you can pay COBRA and some Medicare premiums with an HSA. Unfortunately, not other insurance.
Hey GGG-
Yeah, I saw some of those comments on your most recent post, and I smiled. But in my mind, there is no contradiction. When you were in the accumulation phase, definitely reducing taxable income makes sense. And since your withdrawal phase was ahead and thus unknown, it also made sense for you not to make the money inaccessible in a Roth. But now your situation has changed. The blog has resulted in unexpected income, and despite retiring your net worth has a gone up. So prioritizing Roth makes sense in my mind. Thanks as always for the analysis.
Exactly right, Sam.
GCC, what would you recommend for Roth conversions for an early retired age 50, single, in state with high income tax, and getting ACA subsidies? Even with HSA deduction to MAGI, I can only convert $3000 before I start losing ACA subsidies. I still have $10,000 room at $0 Fed tax bracket, but additional conversions will see 5%+ state tax, lost ACA subsidies (15%), lost property tax refund ($1000).
Mkedst, yes this my concern as well. We have been retired for four years. I did Roth conversions for the first three years. We had did not get any ACA subsidies and lost the property tax credit. At the end of year three, I took enough out of out after tax account to get us through year four to stay under the ACA cliff. My husband turns 60 this year. For next year I came up with the bright idea of using Roth funds so that we can stay under the cliff.
Interestingly, I talked to a Vanguard adviser who thought that was a really bad idea. He thinks we should be harvesting capital gains in our after tax account.
I am interested in other people’s advice on this.
Lynn … I bet the Vanguard adviser didn’t really think about the change to cost of health insurance if your income goes over 400% FPL because of the tax gain harvesting he was proposing, especially in the years when you’re in the ages 60-65 before Medicare. You’ll have some time between 65 and 70.5 to do some tax gain harvesting.
I think for a few years, you’re in the limbo situation of not realizing cap gains (even though they might be taxed at 0% they add to your MAGI), and not doing Roth conversions either, because even if you stay under the ACA cliff, they aren’t really tax free if they involve a ~9% “tax” due to lost subsidies. GCC is able to do some Roth conversions without repercussion because he’s not using ACA for insurance.
You have to look at the marginal rate situation. Is 20% plus $1k now a lower rate than what you will pay later (RMD?) If so, then maybe it is a fair trade.
Alternatively, go abroad for a few years and do massive Roth conversions and cap gain harvesting.
Hi Jeremy, Can you please clarify how living abroad provides a greate opportunity to do massive Roth Conv and cap gain harvesting? Am a single 50 year old retiree planning on moving to Europe for a couple of years. $500K in Traditional IRA, $1.5M in taxable brokerage account. SWR 3%. I retired last year and planning on doing my first Roth Conv this calendar year (2018). Thanks much.
No State taxes and no ACA mean you only have to deal with Federal taxes. See our last 5 years for examples of what can be done.
If you get permanent residency in a country that has a residential tax system on worldwide income (e.g. most of Europe) then you will still be taxed. But stay 3 months in France, 3 months in UK, 3 months in Spain, 3 months in Croatia and you are golden.
Question for GCC
I am 62 and retired. Wife is 60 and working. Her company offers menial health coverage but not for spouses at all. Our combined taxable income from her job and our taxable investment income exceeds $100k. We live in California – 2020 will be first year we need ACA. We are well off the cliff. Premium for decent coverage under ACA for both of us & will cost $2500+ monthly. Yes obscene!! No current Roth IRAs open Is there anything we can do for next 4 years until Medicare to lower this obscene health care expense? Appreciate any insight greatly
You’ll need lower MAGI. Less than 400% FPL, which is about $65k for family of 2. See this.
You can get lower MAGI by contributing to deductible retirement accounts or earning less.
Also consider “good enough” coverage rather than “decent.”
I never did Roth IRAs or 401Ks when I was working, but since retiring five years ago I have started (three years back) moving $ to a Roth IRA account. My purpose is not to use the funds for our purposes; at least that is my plan. It is rather to make sure whatever monies are in that bucket can go to our only child tax-free. Hopefully some administration down the road won’t be so ravenous for $ to spend that they screw up the Roth equation and my plans.
I maxed out my Roth between 2006 and 2015, and I could have had a regular IRA instead, at my marginal rate of 25% it means I left around $12,000 on the table… I started it as an emergency fund but I could have stopped when I had a reasonable amount for emergencies (three years or so) but I kept going. But I don’t regret it, I could have done worse (I could have spent the money…) and now I should be able to write a big fat check not worrying about taxes. I’ve made peace with my decision.
I’ve made peace with lots of youthful decisions as well. Learning is the spice of life, and there are worse things than having a really big Roth.
I do but mainly because my one day a week side gigging generally earns over six figures which means I face a lot of taxes and there is no way I could ever qualify for ACA subsidies. Not saying I’d avail myself of them anyway, but since it is hypothetical I don’t have to worry about it. We actually maxed out our 401k and a ROTH(up until I out earned the right) and then put money in an after tax IRA and into brokerage accounts. I think a ROTH is fine if you’ve filled up all the other saving pots and pans available.
look into a “backdoor Roth”
If you aren’t getting a deduction for the contribution, it is better to also never pay taxes on the gains.
Do Roth conversions count towards the max annual contribution limit?
Crystal … No, conversions from trad IRA to Roth IRA can be done in any amount as long as you’re willing to pay the tax cost related to them. They do not count as contributions for the year, so you can also add to the Roth or to a trad IRA up to your usual limit if you have compensation.
Hmm. I struggle with this. I could just put more in taxable, but since I can’t deduct my IRA anyway, I just put the max in a Roth. Not sure what you advise in such a situation. The vast majority of my savings are in a regular taxable account; I just didn’t see the negative of putting a small amount in a Roth annually.
What do you advise earners who can’t deduct their IRA and are highly invested in a taxable brokerage?
A Roth is fine. There are no negatives if you will have a sufficiently large taxable account.
I know this article in the link below is quite old (2014), but wonder if you’ve seen it, and what your thoughts are? I found it while trying to research brokerage accounts, as I’ve no experience with them. I haven’t been able to find anything on the bill (HR3482 and S1725 – 113th Congress (2013-2014)) re: whether it passed yet.
https://www.pbs.org/newshour/nation/one-use-brokerage-accounts
I am 58 and have simple IRA at work that I max out every year. My income from that job is about $170,000 a year. The way I understand things my income is too high to qualify for a Roth.. I have inquired some about doing a back door Roth, but with the simple IRA at work, some have told me it would be to complicated or not feasible. Is this info basically correct? Is there anyway I can contribute to a Roth IRA now? Currently, in addition to the simple IRA, I am putting a lot of money in VTSAX. Unfortunately for me, I am very late to the FI game and will probably be working another 7 years, until I am 65. Thank you for your ideas on this.
Joseph: You can but you may not want to.
You can max out your contribution to a SIMPLE at work (which has a special higher limit of 15500 for people over 50) and also have a personal traditional IRA to which you contribute 6500 nondeductibly then convert to Roth (backdoor).
IRS says:
“Can I contribute to a traditional or Roth IRA if I’m covered by a retirement plan at work?”
“Yes, you can contribute to a traditional and/or Roth IRA even if you participate in an employer-sponsored retirement plan (including a SEP or SIMPLE IRA plan).”
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-contributions
However — and this is a big proviso — your SIMPLE IRA balance gets counted in the pro rata calculation on Form 8606, just like any other pretax amount in IRAs, and this would mean that a large portion of your Roth conversion would be taxable at your current marginal rate. This is undesirable.
Hi, I really enjoy reading your stories and advice. Now, I really need your feedback. My husband and I have 401K from our employer. We also contribute to a ROTH IRA. However after reading your blog, I was wondering wouldn’t be better if we start a traditional IRA so our contributions are tax deductible then later on convert that into a ROTH IRA. It would make more sense and reducing our taxes. We have one child but our taxes are really high. Thanks.
Maybe. Depends on what your current marginal rate might be. 10% now is better than 12% later.
Hello, I have to admit I love numbers but I hate taxes. Can’t stand it. However, you mentioned that “All gains being tax free is a wonderful thing. I love it. (A lot!) But I also get the same benefit from my taxable brokerage account” is this possible because you claimed the Foreign Earned Income Exclusion (FEIE) which allowed you to once again have income in excess of $100,000 and pay $0 in income tax? I have a brokerage account and every year, every penny is tax either from dividend or capital gains.
Congratulations on your success and high income. It’s possible to earn ~$100k/year tax free in the US also.
Thank you but I am NOT a high income. I don’t even make 6 figures. As you know, middle income pays lots of taxes. I am one of them.
Huge fan of your blog GCC, thanks for digging into why you contribute to Roth’s now and didn’t when you were accumulating :)
For my situation, I make a considerable amount with my salary and am on track to early retire around 38-40 (depending on the market). I am currently 28. I don’t hope to have a family until I’m 40 or 45, if at all (haven’t really decided yet, but am open to the opportunity).
If I don’t have a family, I am pretty sure that my savings will last me till death as a single guy; even with the increased premiums for healthcare. My question to you is, if I do decide to have a family, is it worth it working a government job for full healthcare when I retire from my current job?
I am pretty sure that for most government positions, you only need to work 5 years to be covered under basic healthcare benefits (70-75% of total cost) when you “retire” (see link below). This is somewhat feasible if at 38, I go to work a part-time post-office gig or something along those lines specifically for the benefits, and call it quits at 43…
If I was willing to work for an additional 5 years (and maybe have a family afterwards at 43-45), is this a feasible scenario?
Thanks!
http://gogovernment.org/government_101/benefits.php
Working longer for cash and/or benefits is always a feasible scenario, health permitting.
Another instant classic by The GCC ( ya you know me )…and worth a bookmark/re-read/ print off + lamination ( if that’s one’s thing ). I joined a company where the Mega Roth Conversion is made possible. If nothing else it will be bequeathed to my daughter sans any tax strings attached ( per GCC bylaws and core principles ).
You down with GCC?
I’ve run across this site a few times after spending some time reading about long term investing. I got here trying to figure out what I should with this random Roth I’ve had in my account from one of my past employers. My retirement investments are a mess. I’m 50 years old and I’ve done a bad job at coordinating what I have strewn across 401k’s from several different companies I have worked for. I have ESOP, ESPP’s and a roth somewhere too. And at one point I did a rollover into an account that has not performed. I have very little idea of what to do but want to consolidate my accounts to one place with maybe a little help to get me straightened out. I have probably too much cash and too many “one off” stock purchases that have mostly lost over the years. It’s actually embarrassing to admit all this. I feel the need to rake it all into one place and just face reality, start a new plan, and be far more strategic in my personal financial plan. Worse, i work for a start up with no retirement benefits (theoretically, there is upside elsewhere in working for them). Anyway… is there an investment house that is able to hold my hand to start, then not kill me in fees if I stay with them? I am starting the “facing the reality” phase and want to move forward. This is probably more of a public confession :-)
Congratulations on taking the first step.
A fee only financial planner can help you point the ship in the right direction. You could also look at Vanguard’s planning services.
I contribute to a Roth 403b.
My situation: my wife and I work for the same company which actually still has a pension. We are five years in, so we are vested. My wife is doing PSLF so we maximize her Traditional 403b (to minimize her AGI which lowers monthly PSLF payments).
I figure with a decent Traditional 403b for her, and two good pensions, we will have decent retirement income not including SS.
My other concern is politics. My thought is that if the US continues to be economically viable, between debt, healthcare and SS, it will have to increase taxes.
I’m so thankful I came across your blog! I think your strategy is genius. What do you think about saving for kids’ college in a roth? I inadvertently discovered through paying for my own college that funds used from 529 savings accounts disallow credits, so I switched approaches. Do you think this is a good idea? How are you guys saving for kids’ college? Thanks!
-Kristen
I don’t know what disallow credits means. Roth withdrawals will reduce future eligibility for aid (it increased expected student burden.)
If we need to pay for anything, we’ll do it from our taxable portfolio. We have no 529.
How does this article not mention the fact that you only get the tax benefits of a traditional IRA if you make under 64k??? That’s a pretty big deal.
A few reasons. First, because it is not completely accurate. Second, because the topic of discussion is weighing the pros/cons of contributing to a Roth vs a taxable account. Third, because it’s not a big deal – if you don’t qualify for a deduction to a Traditional IRA, don’t contribute and see point 2.
I’ve been reading your posts lately. Thank you for the great insight. Hypothetically, say you were in the 22% from W-2 work and also earned say $10000 from a side hustle still in the 22%. Would you contribute that $10000 to traditional solo 401k or Roth solo 401k where you could still get the 20% QBI deduction. Sorry for the long question!
Hi Spencer
I think the simplest way to look at this is to compare your marginal tax rate on contribution vs withdrawal. If tax rate now < tax rate future, then Roth is better. We just need to adjust the tax rate for the fact that a Traditional contribution means we pay tax now on 20% of the contribution due to loss of QBI deduction but have to pay tax on 100% of the withdrawal, so in effect instead of 22% we pay 26.4%.That said, if you are making a full 401k contribution at the W2 job then you only have the option of making after-tax contributions or employer contributions. Employer contributions are always Traditional / pre-tax. My solo-401k contribution calculator may help think through it.