One of the goals I have before I retire is to convert the majority of our retirement accounts over to Roth balances. You don't have to search too hard to find folks who can show you how mathematically the Traditional IRA is superior because of tax deferral, or how lower tax rates now reward those who deferred taxes in prior years.
But personal finance is personal. You can't always just rely on math and always choose the most optimal solution. Just like I could show you how mathematically we're foolish for having paid off our house early, there are real but intangible benefits to the peace of mind I gained from doing so.
Having more of our retirement assets in Roth accounts is one of those things. Here's a few stories of things I've seen that have shaped my feelings on this topic.
Phantom Money:Years ago, I met with a couple in their late 60's who lived in a part of the country hit very hard by the housing crash. Due to a series of sub-optimal decisions and unfortunate timing, they found themselves trying to sell a house that was worth about $100k less than what they owed on it.
The wife in this couple had mostly been a homemaker but had held a part-time job for several years that allowed her to contribute to a 401(k). After many years of growth, this account was worth around $100k at the time we met. Seeing a potential solution to their being underwater on their mortgage, she asked me 'Well, can't I just use that $100k to pay down the mortgage and be done with the house'?
I'll never forget the look in her eyes when I had to explain that taxes would be due on the amount withdrawn from her 401(k) and that the $100k balance she had become used to seeing on her statements, would really only be ~$70k, still leaving them $30k in the hole. Up to that point, she had always thought she had $100k, when in reality she never actually had the amount on her statement available to her.
There are ways to take money out over time to minimize the tax consequences, but that wasn't an option when they needed a large amount of money in a short period of time. It's hard not to see your balance and think about what you could get for it, but whenever you see a pre-tax 401(k) balance you should always see that number and deduct ~25%. Our Roth accounts on the other hand, are all ours.
Too Much Tax Deferral:
Is there such a thing as too much of a good thing? Most certainly yes, even in deferring taxes. I've met with several retirees whose primary strategy in their working years was to save as much as possible into tax deferred accounts, with little to no thought put into a withdrawal strategy.
One particular scenario that stuck in my mind was a client who had saved about $5M for retirement and going into retirement had based their expectations upon a certain level of fixed income to come from those assets. Throughout their careers they were usually in the highest tax bracket, and had put as much as they could into every tax sheltered vehicle possible, including deferred compensation accounts. This was done partially with the belief that in retirement, their tax rates would be lower.
At the point we met, they were within a few months of retiring and finally starting to look at a withdrawal strategy. What became clear fairly quickly was that because of the requirements on deferred compensation payouts and timing of Minimum Required Distributions (MRDs) from retirement accounts, it was going to be virtually guaranteed that they would still be in the same, highest tax bracket for at least the first 15 years of their retirement.
Yes, this is a great problem to have. But it just goes to show that withdrawal strategies need to be considered early on. With the benefit of hindsight that client wishes they had done some Roth conversions earlier in their careers even though the tax bill at the time seemed unpalatable. They also maybe wouldn't have deferred as much income and would have just done non-retirement investing (the deferred comp account only earned CD-like returns), or possibly even retired sooner.
Lessons Learned and Our Strategy:
I have two main takeaways from these examples. First, never look at a pre-tax investment account balance and think that whole amount is actually yours. I would much rather have a $100k Roth IRA than a $100k Traditional IRA. Second, planning withdrawal strategies needs to be on your mind throughout your accumulation years. Asset location (the type of account) is as important as asset allocation (the type of investment).
As mentioned before, our strategy is that we want as much in Roth accounts as we can afford to by the time we retire. This means that all 401(k) contributions we make go in as after-tax contributions. This reduces my take home pay by more than if we did pre-tax contributions, but also means we're putting more away into retirement accounts than if we did the same percentage of income but pre-tax.
Each year, we also pay the taxes on a portion of our pre-tax accounts and convert that balance to Roth. We have a lot to still convert with only about 1/3 of our total retirement accounts in Roth, but we are still 10+ years from retirement so should be able to make very good progress between now and then. Also now that we are no longer paying a mortgage, we can afford to convert a bit more than we were doing in previous years.
Lastly - we plan to be retired younger than age 59 1/2, which means that we can't solely rely on our retirement accounts to live on for the time before we hit that age. With the house paid off, we are now contributing monthly to our non-retirement investment accounts an amount similar to what our minimum mortgage payment was. This amount, while taxable, is what will get us to age 59 1/2 if I retire in my early 50s.