Using a Roth can deliver a big payoff when you retire, by Suze Orman

Given we are in the heart of tax season I know many of you are focused on ways to save on this year’s tax bill. And you are grumbling that you are determined to reduce next year’s as well.

But I think when it comes to how you save for retirement, it can be smart to choose a type of account that doesn’t help you lower your tax bill today. Yes, you read that right: I am making a case for a retirement savings strategy that doesn’t deliver any immediate tax break.

I am talking about Roth Individual Retirement Accounts (IRAs) and Roth 401(k)s, which are different from Traditional IRAs and 401(k)s. 

Hear me out on why I think saving in a Roth rather than Traditional accounts can be a big retirement win.

A very short course in Roth v. Traditional retirement accounts

Our federal tax system offers incentives to get us to save for retirement. With retirement accounts, the incentive is a tax break. The biggest difference between a Traditional retirement account and a Roth retirement account is when you get your tax break.

• Traditional tax break: Your tax break comes when you contribute money to a retirement account. The money you contribute reduces your taxable income from the year. So for example, if you have an income of $70,000 and contribute $6,000 to a Traditional IRA, that $6,000 is deducted from your taxable income, so you would be taxed on just $63,000 for the year.

In return for that tax break, you are making a deal with the federal government that in retirement you will pay income tax on every dollar you withdraw from traditional retirement accounts. (And as I explain below the federal government will force you to make withdrawals. It wants its tax revenue!)

• Roth tax break. The money you contribute to a Roth account does not help reduce your taxes in the year you make the contribution. That is, you get no tax break right when you contribute. Instead, your tax break comes when you are ready to use your money in retirement. Every dollar you withdraw from a Roth account would be 100% tax-free if certain conditions are met. You heard me: no taxes.

Who might benefit from using a Roth retirement account

I want to be clear that I think any and all retirement savings is great. There is nothing wrong with saving in Traditional accounts. I just think that there are plenty of reasons why saving in a Roth can be smart(er).

Here’s when I think Roths are a great move:

• You’re in a low federal tax bracket today. If you have yet to hit your peak earnings years—hi Gen Z and Millennials!—the value of getting a tax break on today’s contributions isn’t going to be worth much. I think at this life stage, a Roth is a no-brainer.
• You are working on building up your emergency savings. I have been so thrilled to hear how many of you have an Ultimate Opportunity savings account with Alliant.¹⁰³ As I have shared with you before, I am well aware that it may take months—maybe even a few years—to build up your emergency fund to the point it can cover 12 months of your essential living expenses. That’s more than okay. Each month that you are saving you are moving closer to your goal.

When you have yet to build up a very large emergency savings account I think a Roth IRA can be extra smart to consider. That’s because every dollar you contribute to a Roth IRA can be withdrawn at any time without owing any tax or penalty. (It’s just your earnings in a Roth IRA that you don’t want to touch-as they can be hit with tax and penalty). That’s different from a Traditional IRA where you will owe income tax on any withdrawals, and if you are younger than 59 ½ you will also owe a 10% early withdrawal penalty.

I want to be very very clear: I am not recommending taking money out of a Roth IRA before retirement. But when you’re still building up your emergency savings, it can help you sleep better knowing that in a dire situation you could withdraw Roth contributions without tax or penalty.

• You appreciate that today’s federal tax rates are near historic lows. I don’t possess a crystal ball, but we have low tax rates today and a high deficit. I wouldn’t be shocked if rates rise. That means that even if your income is lower in retirement, tax rates could well be higher than they are today. That’s another reason to pay your retirement tax today by saving in a Roth.
• You’ve done a fantastic job saving in Traditional accounts. For decades, Roth 401(k)s did not exist. Anyone who’s been working for a while, and diligently contributing to their 401(k) likely has money in a Traditional account. That’s more than okay—it’s fantastic you committed to saving! But as I mentioned earlier, every dollar withdrawn in retirement will be treated as income. My advice is to consider using a Roth for your new contributions, as a way to build up some savings that will be 100% tax-free when you use the money in retirement.
• You don’t want to be forced to make withdrawals in retirement. As I mentioned earlier, when you save in a Traditional account you are agreeing to pay tax on money you withdraw in retirement. And because the government is so intent on collecting (finally!) its tax from you, it forces savers with traditional accounts to start making withdrawals no later than age 72. These are called required minimum distributions (RMDs). I want to be clear: you can make withdrawals earlier and you can withdraw as much as you want. The RMD rule exists to force people who don’t need to withdraw money to make withdrawals. Money in Roth accounts is not subject to the RMD rule.

How to save for retirement with Roth accounts

• Roth IRA rules. In 2022 you can contribute up to $6,000 in a Roth IRA if you’re younger than 50. If you’re 50 or older you can contribute $7,000. Individuals with income below $129,000 this year and married couples filing a joint tax return with income below $204,000 can contribute up to those maxes. Above those income levels, you may be able to make a reduced contribution, but once income is above $144,000/$214,000 you are no longer allowed to directly invest in a Roth IRA.
• Roth 401(k) rules. The majority of 401(k) plans now offer participants the choice of saving in a Traditional 401(k) or a Roth 401(k). That’s a big change compared to a decade ago when few plans offered a Roth. Anybody with a Roth option is allowed to contribute. There is no income test with Roth 401(k)s. In 2022, the maximum 401(k) contribution is $20,500 if you are younger than 50, and $27,00O if you are 50 or older.

But you need to take the initiative to ask that your contributions be made to the Roth 401(k). Plans that automatically enroll new employees choose the Traditional 401(k) for them. All you need to do is ping HR and ask for your new contributions to be made into the Roth option. (I want to be very clear here: You do not want to move your existing Traditional savings into the Roth account. That will trigger a big tax bill. I recommend consulting a tax pro before you consider that move. What I am suggesting is that you make future/new contributions into the Roth 401(k) option.)

If you choose the Roth 401(k) and your company offers a matching contribution, I want you to be aware of an odd quirk: That matching contribution will be made into a Traditional account. Nothing you can do about it. But I just want you to know how it all works.

Roth IRA or Roth 401(k) 

The question I get asked all the time is which is better. It depends.

A Roth 401(k) might be all you need to use if your plan offers investments that charge very low fees. Every fund in a 401(k) plan charges an annual fee called the “expense ratio.” If your plan offers index funds that charge no more than 0.10% or so, that’s great. 

Higher expenses? Always contribute enough to the 401(k) to get the company match, but after you reach that level, I would recommend focusing on saving in a Roth IRA. Once you max out on your annual Roth IRA contribution it’s fine to contribute more to your Roth 401(k).

If your workplace plan doesn’t offer a Roth option, I always want you to contribute enough to earn the maximum employer matching contribution. But once you’ve hit that mark, you too should consider saving in a Roth IRA.

And if you’re reading this before April 15, 2022, I want you to know that you can still make a contribution to a Roth IRA for the 2021 tax year, up until the federal tax filing deadline. Anticipating a tax refund? I would put saving in a Roth IRA high on your list of smart uses for that money. 

The information in this article is for general information only and is not intended to provide specific advice or recommendations for any individual, as each individual's tax situation and investment risk tolerance is different. While the information provided is based on our understanding of current tax laws, and has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. To determine which investment(s) may be appropriate for you and how you might potentially reduce your taxable income now or in retirement, consult with your tax professional and financial advisor to discuss your personal situation prior to investing.