Why You Should Fund Your Roth Even If You Won't Need It
If you’ve read anything from the financial independence community, you’ve read about Roth IRAs. They provide tons of benefits to all retirees, like tax-free growth and the absence of required minimum distributions. There are some benefits more applicable to early retirees, like the ability to access principal before age 59.5. But, what if you don’t need to access principal early, or expect to have enough passive income to sustain your retirement without withdrawing from the Roth IRA? Beyond the absence of required minimum distributions, would it make sense to contribute to the Roth IRA or make Roth conversions?
There are a few other benefits of Roth IRAs that would still make them a good option for most.
Tax Planning in Retirement
Similar to planning for Roth conversions in early retirement to take advantage of lower tax brackets, withdrawing from Roth accounts in retirement can help you plan around the brackets later in life. If you are in your 70s and required to take traditional IRA required minimum distributions, plus taking social security, you may be close to the top of your tax bracket. If you need additional money, you may end up in the next tax bracket based on the source of those funds. Enter the Roth! You can take withdrawals from your Roth IRA with no tax implications.
This may seem anathema to those in this community, especially after discussing the inheritance benefits below, but it is simply tax rate arbitrage going the other way.
Inheritance Planning
Even if you don’t anticipate needing to take distributions from your Roth IRA during your lifetime, there are compelling reasons why you should consider converting assets to a Roth. After you pass away, any non-spousal beneficiary (think children) would be required to take those required minimum distributions (RMDs) you were exempt from when you held the account in your name. The inherited IRA RMDs are calculated with the same factor whether it is coming from a traditional IRA or a Roth IRA. However, when the beneficiary takes these distributions, the tax implications are the same as if the original owner were to take the distributions. That is, the Traditional IRA would be taxable and the Roth is tax-free
Therefore, in thinking of which assets to leave to heirs, the Roth IRA is much more valuable, especially since your children may be still working when you die. They would then be withdrawing from the IRA at potentially the highest tax rates of their lives. For those wealthy enough to pay estate taxes, doing Roth conversions is effectively a gifting strategy, as they are paying the taxes now instead of forcing their heirs to pay it later!
While the Federal estate tax has increased substantially, some states still impose inheritance taxes at a much lower level. Doing Roth conversions and paying taxes at the original owner’s rate may be preferential to paying both the estate tax AND the inheritor’s income tax rate. For example, a $1,000,000 IRA could be converted to a Roth at a 22% rate over a few years. Consider the example of a state that imposes an 8% inheritance tax (like DC, above $2 million), plus the inheritor’s income tax at 22% (due to earned income plus RMDs). Doing the Roth conversions would save a significant amount of money for the heir. Paying the income tax during the original owner’s life could reduce the size of the estate such that no estate tax would be owed at all!
Let’s Talk About Success
It is kind of a knee-jerk reaction to think that having more in Roth IRAs will mean your plan has a higher chance of success. It makes sense intuitively that having tax-free assets available in retirement should translate, right? However, unless you are truly spending down all of your assets in retirement, having Roth IRAs instead of Traditional IRAs doesn’t really impact your success rates. This is because if you don’t spend down the Roth IRAs, the benefits are never realized. It is the second generation where the success rate increases, namely the higher after-tax value of the Roth account. This is because the heir is actually withdrawing from the account and realizing the benefits of the Roth IRA.
It’s not like Roth IRAs needed another cheerleader. The benefits are clear, but I hope these additional benefits can show another important side of Roths, especially later in life.
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