Should You Prioritize Roth Contributions Even with a High Income?

I love this question from Suma because I think it’s one that a lot of people with higher incomes are asking. Should Roth contributions be reconsidered for high-income work accounts? Pre-tax contributions will be in the eight-figure range by the time we have RMDs, which should push us into a high tax bracket. So, I imagine they are on the other side of the Money Guy Rules, and the rules say they should be contributing pre-tax now to save tax. But they already have so much in pre-tax, and their RMDs will probably be substantial. So, does it ever make sense to do Roth for high income?

Well, we get this question all the time because a lot of people do linear projections around what their accounts are doing. “I’m putting this much in my 401k, and if it continues to grow at this rate of return, by the time I get to RMD age, by the time I get to 75, it’s going to be worth this much money.” While that may be true, what we actually find in practice is that there are strategies that you can implement before you get to RMDs to start impacting and affecting that decision. Most of the folks, and I would argue, Sumo, if you’re in this position, if you’ve been saving really well and you’re building up your army of dollar bills and you’re approaching Financial Independence, there’s a chance that you’re probably not going to work all the way until you get to age 75. What’s most likely going to happen is you’re going to retire—maybe it’s at 65, maybe 60, maybe 55. When you retire, all your earned income is going to go away. You’re not going to have any other income coming in. So, if you’ve been doing step seven of the financial order of operations and you’ve built up your three distinct tax buckets, you’re going to get to pick and choose what kind of tax rates you pay. You may live off of your after-tax account, only have to pay income tax based on any capital gains you’re generating. To do that, well, then you can manipulate the lower parts of the tax code by doing Roth conversions later in life. You might have the ability post-retirement but pre-RMD to turn those pre-tax dollars into Roth dollars at a much lower tax rate.

So, the question you have to ask yourself is, “Okay, would I rather, let’s assume that you’re in the highest tax bracket, 37% federal. Would I rather pay 37% taxes to get one Roth dollar this year, or would I rather wait until the future and maybe pay 22% to get that pre-tax dollar turned into a Roth dollar?” In our experience, there’s a lot more opportunity later in life when you can control your income than when you are in these early high-earning years.

Yeah, I mean, I wrote down three quick things. One was WR tax rates in the future. Nobody really knows what they’re going to be, but here’s what I do know, and this is the only thing that’s kind of bipartisan: all elected officials are scared of old people. I mean, because old people vote. So, it’s very common that you see a lot of legislation in the tax code that kind of gives a nod to retirees. And that’s why I don’t know. I think we all probably are thinking tax rates will go up in the long term just because of the obligations of the country. But it is one of those things where even with tax rates going up, there’s going to be a nod towards retirees. Look at all the states. Like, we come from the state of Georgia, we live in Tennessee now, but Georgia exempts out a lot of retirement distributions, big chunks of this, not even just cost-of-living-type stuff. It’s big chunks. I see this in other states across the Union where they really incentivize tax rates on retirees. So, there’s a good chance there will be a planning opportunity as a retiree that workers who have earned income are not going to have. And then that goes with also, once again, a nod towards tax legislation changing to give something to the older voters.

RMDs have been going up. I mean, it was just a few years ago when 70 and a half was when you were required to take required minimum distributions, which is your fear, Sumo. But now look, they went from 70 and a half to 72, and then most recently, they’ve gone to 75. So, the trend has actually been giving you more time before you’re required to take the money. So, if you combine that with the nods that they give in the tax code to retirees, you’re likely, if you retire anytime before 75, going to have a period of time to essentially game the tax code legally by having a Roth conversion strategy, just like Bo talked about.

I know it stinks in the fact that you’re thinking about, “Man, I’m in a high tax bracket right now. I love seeing that every dollar I put in, because I know money multiplier and other things, that my money is growing, and it’s growing, and it’s going to be tax-free.” But I will tell you that paying 37% plus whatever your state income taxes, if you’re getting in a situation, think about if you lived in California or something where 50% of your income is going towards taxes, there’s a lot of room there to fund retirement, take the deduction now, so the government’s essentially funding half of your retirement contribution. And then look for unique opportunities in the future where you can convert at a much lower tax rate. And now, while you can take advantage of tax-free opportunities that do exist, maybe you can do backdoor Roth contributions, maybe you can fund a health savings account, maybe your employer has after-tax 401K contributions, and you can do the mega backdoor Roth because you’re high income and you can save at that level. So, just because you’re not doing the salary deferrals in Roth does not mean that you do not have opportunities to build tax-free dollars. For more information, check out our free resources.