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?
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…
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.)
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!”
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!
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.
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?