IRAs, 401ks, ROTHs: Which Retirement Account Should I Use?
By: Brian Seay, CFA
IRAs, 401ks, the TSP, ROTHs.
It’s a soup of acronyms. What's the right prioritization of accounts for saving? Which account should you spend from first in Retirement? What if you’re a business owner and don’t have retirement benefits?
In this episode I’m diving into the main retirement account types and how to use them. I'll cover:
1) Accumulating wealth…when you’re saving for retirement and
2) Decumulating wealth...or spending your assets in retirement.
We will talk about contributions, backdoor contributions, income limitations and common misconceptions. So if you have questions about which retirement accounts to use – you’re not alone – and this is the episode for you. If you would prefer, you can read the article below the video, which covers most of the content from the episode.
There are no “tax-free” retirement accounts, the question is when to pay taxes.
I want to start with is an overarching framework that may help you think about which accounts to use when, even if you forget some of the specifics when we dive into the details.
That framework is simple: you want to pay taxes when your tax rate is the lowest.
There are no “tax-free” retirement accounts. Another common myth is that ROTHs are always better than 401ks or vice-versa. If your tax rate stays the same, there is no difference between investing in a ROTH and a traditional retirement account. The different account types simply have different timing for making tax payments on the income you contribute to the account. So, the big question to answer is whether to pay taxes now or pay taxes later.
Understanding your relative tax position and marginal tax rate is actually the most important piece of information when deciding what kind of account to use in my opinion. By relative tax position, I mean your current marginal tax rate compared to your potential marginal tax rates in retirement. Is your current rate higher or lower than your rate may be in retirement?
The problem of course, is that very few people even know what their marginal tax rate is today, much less what it might be in 10 years. So, there is a good reason to go talk to your advisor or your CPA. Make sure you know what your marginal tax rate is and do a little planning to attempt to project it in the future.
Now let’s dive into the account types and whether they fall into the “pay taxes now or pay taxes later” buckets.
Retirement Account Types
All retirement and investment accounts fall into three categories. I like to think of these as buckets.
The first “bucket” of retirement account type is tax deferred accounts. In these accounts you get a tax deduction today for contributions up to a certain threshold and you pay taxes in retirement on the distributions from the account. Examples include traditional 401ks and traditional IRAs for private sector employees. If you work for the government or a non-profit, you may have the TSP, a 403b plan or a 457 plan. All of these are tax-deferred accounts. So, if I think my tax rate is high today, and it will be lower in retirement, I want to use tax deferred accounts first.
The second bucket is ROTH accounts. These can include traditional ROTH IRAs and the ROTH side of a 401k or other retirement plan at your employer. In ROTH accounts, you pay taxes on the income used to make contributions today, but then the growth and future distributions are tax-free. So, if you expect your tax rate to go up over time, then ROTH accounts should be your primary focus because you pay taxes today at a lower rate.
The third bucket is a standard taxable savings or brokerage investment account. Contributions to retirement accounts are limited so eventually you may need to save more than you can contribute to a retirement account. In taxable accounts, you pay taxes on the income when it’s earned, and since it’s not inside a retirement account, you also pay taxes on future gains and income. However, those future taxes are at lower capital gains and hopefully preferred dividend rates.
I talked a lot about employer sponsored plans, but if you are a small business owner, an independent contractor or 1099 worker, you may not have a formal employer sponsored option. But there are still options for you on both the tax deferred side of the ledger, like solo-401ks or SEP and SIMPLE IRAs; and on the ROTH side of the equation as well. While the same tax framework applies, the specific account types just may be slightly different and come with different rules depending on your business and savings objectives.
So now that we have an idea of what we are working with, let’s talk about which accounts we should use when we are building wealth, then we will move to decumulation and retirement spending.
Which Retirement Accounts to Prioritize for Retirement Saving
When you are saving for retirement in the early to middle part of your career, you are likely in a lower tax bracket than you will be in the middle and end of your career when your earnings are the highest. The logical answer is to prioritize investing in ROTH accounts, right? Well, maybe.
Generally, regardless of your stage in life and income, the absolute first place you want to save is in a 401k that provides any kind of employer match. If your employer matches your savings dollar for dollar or even 50 cents on the dollar, that is effectively a 100% or 50% return to you overnight. No tax planning benefit will ever overcome those matching benefits. The first place to save is always your employer plan that has a match. If you can receive matching dollars for ROTH contributions, then that’s even better, but make sure you get the match even if it’s to a traditional 401k, the TSP or some other kind of plan.
After you contribute enough to receive your employer’s match, then, if you are earlier in your career, you should likely focus on ROTH contributions. You may be able to elect ROTH contributions to your 401k. There are no income limits on ROTH k or ROTH 401k contributions to a plan sponsored by your employer. If can’t contribute to an employer ROTH plan, and your taxable income is below the Modified Adjustable Gross Income Phaseout Threshold, you can contribute directly to a ROTH IRA.
The challenge with direct ROTH – IRA contributions is both the income threshold and the maximum contribution. You may only contribute $7,000 in 2024 if you are younger than age 55. So, what if you want to save more than $7,000? The third priority, after getting any available employer match and direct contributions to a ROTH 401k or ROTH IRA, is back-door ROTH contributions. You might have also heard this described as “mega-backdoor ROTH conversions or contributions. The strategy here is to make after-tax contributions to your 401k plan and then roll those over to a ROTH. This process can be complicated and there are a lot of rules to consider. There is an entire post on my blog about ROTH conversions and backdoor contributions, questions to ask and potential pitfalls. So if you are thinking about backdoor ROTH contributions, I suggest working with an advisor or your tax professional to make sure you execute the strategy correctly.
So early to mid-career when your tax rate is lower, start with matching contributions to a retirement account, then look for ROTH contributions either directly to a ROTH IRA or ROTH 401k or indirectly though backdoor ROTH conversions.
As we move into the middle and latter stages of our careers, typically our income and tax backet goes up. It’s important to note that in this discussion, I’m assuming that this will happen. There are careers where income may be more stable over the course of your career, if that’s the case, then some of this may not apply directly to you, you might need a more balance ROTH and tax-deferred approach over the course of your career.
If your income is rising, then your taxes go up, and then you should prioritize contributions to traditional deferred retirement accounts like 401ks, traditional IRA, the TSP, 457 plans etc. By making contributions to traditional accounts later in your career, you are likely getting the tax deduction on your contributions at the highest rate possible. Now, later in your career, you may have enough income to save beyond the $23,000 that you can get a tax deduction for in 2024. So, you shouldn’t stop saving via ROTH accounts if you are able, just prioritize traditional tax deferred accounts.
So later in your career, the priority should be Tax deferred accounts like IRAs or your 401k and then making additional contributions to ROTH accounts or standard taxable brokerage accounts. BUT, there is a big caveat here.
I often find mid to late career professionals have been piling the maximum into their tax-deferred 401k for years and now their 401k represents most of their assets. I call this maxing your taxes by maxing out your 401k contributions! This is not a good idea!
But we can’t go back to when we were 30 – so let’s talk about what to do going forward. It’s important to look at long-term tax projections to determine whether to keep funding a tax deferred account like your 401k or to start making ROTH contributions. If all your assets in retirement are tax deferred, your tax bill down the road may be even higher than it is today. This may be especially true in your 70s when you take the required minimum distributions annually from your tax deferred assets. So, tax planning is important because it may make sense for you to balance out your existing tax deferred holdings with ROTH contributions, even though you are in a relatively high tax bracket currently.
Our initial framework still holds, which is to pay taxes when your rate is the lowest. Long-term tax planning can be helpful in retirement account contribution decision making as you get to the middle and end of your career. And this is one place where one-size does not fit all. Understanding your current tax rate today vs. in retirement becomes vitally important to reducing your taxes over the long-term.
How to Prioritize Retirement Account Distributions in Retirement (Decumulation)
Alright, so let’s talk about decumulation, or spending in retirement. Again, the goal is to lower our tax rate over the long-term. In my experience, this also generally means having consistency in tax rates in retirement. So if our goal in accumulating wealth was to lean heavily on ROTH, taxable or tax deferred contributions in a given year, in retirement, more balance generally delivers optimal results. You might assume that letting tax deferred assets continue to grow would produce better results, but the government starts to force taxable distributions from those accounts in our 70s, these are called Required Minimum Distributions. So, if you let your tax deferred assets grow and grow, then in the few years where we are required to take distributions, those distributions will be large and require you to pay high marginal tax rates.
Your situation may differ, but taxable income tends to go down slightly early in retirement. In those years, we want to spend roughly evenly from our tax deferred IRA or 401k and our taxable investments. It may also make sense to do ROTH conversions from your 401k in these years to get money out of a relatively large 401k or IRA that will be taxed heavily down the road.
In those early years, you might do things that drive your tax rate up marginally! But this should help prevent your taxable income from spiking from required minimum distributions down the road. As you move through retirement, you want to rely more on your ROTH savings and less on tax deferred accounts (other than your RMD). Once you start taking required minimum distributions, the goal is to fund your remaining withdrawal needs with tax-free distributions from ROTH style accounts.
Lastly, ROTH assets are the best assets to hold for as long as possible. Because the taxes are paid, every year of tax-free compounding drives more after-tax wealth for you. So spend your tax deferred assets and your standard taxable brokerage accounts first, and hold on to the ROTH as long as possible. ROTH assets are also good assets to leave to your family because the taxes are already paid!
Conclusion
Now, there are exceptions to every rule, and your situation may differ from our “ideal” lifetime saver based on your career path, earnings, assets that you own etc., so it’s important to work with a financial planner and tax professional to understand your current and future tax rates.
Regardless of your situation, I hope this gives you a basic framework to use when you think about retirement saving. The goal is to reduce your taxes over the long-term, so again the basic framework is to pay more in taxes when your rate is relatively low and pay less when your rate is relatively high. You can use contributions and eventually withdrawals from retirement accounts to accomplish this goal. If you have questions about applying this to your situation, I’m happy to discuss further anytime.