If you have a retirement account, either through your employer or on your own as an IRA, it is more likely that you have a traditional type (pre-tax) account rather than a Roth account. This is not surprising as Roth IRAs were only introduced in 1997 and many employers still do not offer a Roth 401(k) or Roth 403(b) option. Even as Roths have grown tremendously in popularity, the average traditional balance is far larger than the average Roth account balance.
Regardless of the type of account, the most important thing is that you are saving enough to fund your retirement successfully. With that said, we do need to pay some attention to the difference between a Roth and a traditional retirement account. Just as you have invested in a variety of different types of assets, it is also important to diversify the tax treatment of your portfolio. And here’s why…
Imagine your future. You are happily retired, taking regular distributions from your traditional retirement account and paying income tax on these amounts each year as required. But then…your car dies. Luckily, you have ample savings and you take a larger than normal distribution to pay for a new car in cash.
But what happens next?
- When you prepare your next tax return, you will declare as income not just the normal amount that you always withdraw, but also the extra amount that you spent on a new car.
- Now your taxable income is much higher than normal. In fact, high enough that your Social Security benefit which was previously untaxed, may now be partially taxable as income. Perhaps so high that you may be pushed into a higher tax bracket. Possibly high enough that your Medicare premium goes up.
And you have a big check to write to the IRS for taxes owed that you did not expect.
You can avoid this outcome fairly easily by directing some portion of your future retirement savings to a Roth account, either an IRA or a Roth 401(k)/403(b). Any distribution from your Roth account will be entirely free of taxes; it is not counted as income on your tax return. In this way, as you save for retirement you are making sure that when needs must, you will have the ability to tap into a portion of your retirement savings without incurring an unpleasant tax surprise.
Of course, you can also convert some of your existing traditional retirement account assets to a Roth account, paying the income tax immediately when you do so. (Many people do this when they anticipate being in a higher tax bracket at retirement.) But if you have some years of saving ahead of you, there is no need to do so in order to achieve tax diversification in your retirement portfolio; just do it going forward.
It bears repeating: the most important thing is the amount that you save for retirement. But don’t overlook the opportunity to fine tune your retirement saving strategy to avoid future unpleasant surprises. For more guidance like this, start your Hey Money subscription today!