Roth accounts (IRAs, 401(k)s, 403(b)s) are awesome, and expanding the size of your Roth accounts is a worthy goal for any investor. Everyone knows that Roth accounts provide for income-tax-free withdrawals, but sometimes they forget about the other benefits of a larger Roth- including better asset protection in most states, and two significant estate planning benefits- stretch Roth IRAs (completely tax-free for decades after your death) and the ability to lower the size of your estate below the estate tax exemption by getting “the government's portion” (the taxes due on a tax-deferred account) out of the estate.
There are a number of ways to expand your Roth space, some of which come with significant costs, and some of which are a no-brainer. Today we'll go over 9 of these ways, and point out which ones you should already be doing and which ones you ought to consider now and in the future.
9 Ways to Expand Your Roth Space
#1 Preferentially use Roth Accounts During Low Earning Years
Early in your career, especially if you're a medical resident, you have a lower marginal tax rate than you will the rest of your career and probably your retirement. The same goes for any year in which you have significant unemployment, take a sabbatical, or work part-time. Be sure to max out any personal and spousal Roth IRAs, Roth 401(k)s, and Roth 403(b)s in these years, even if you have to pull from taxable accounts to do it.
Bottom Line: No Brainer
# 2 Fund Roth Accounts First in the Year
The first week of January every year I fund my personal and spousal Roth IRA (via the backdoor). The initial tax break for funding a tax-deferred account doesn't show up for 16 more months, but the tax benefits of a Roth IRA begin to accrue from the moment you fund it. Why not fund it first? Compared to money contributed in December (or worse, next April) January Roth contributions get 12-16 more months to grow!
Bottom Line: No Brainer
# 3 Spend from Roth Accounts Last
Many very wealthy folks have chosen to spend from their Roth accounts last in retirement (and many of them never actually get to the Roth money). This costs them more taxes than they would otherwise personally pay, but it results in additional asset protection, and perhaps a lower overall tax bill for the extended family. This strategy may lower or eliminate the estate tax due and gives heirs tax-free growth and withdrawals for decades afterward.
Bottom Line: Significant Tax Cost
# 4 Place Bonds in Taxable
Some people still don't quite get this. When making asset location decisions, too many people only look at the tax-efficiency of the asset, but forget to consider the expected return of the asset. In order to properly asset locate, you must consider both of these aspects of each asset class you own. By putting low expected return assets (like bonds) in taxable, your Roth accounts will grow faster than they otherwise would.
Bottom Line: No Brainer, but run the numbers first
# 5 Use Roth 401(k)/403(b) When Tax Bracket Arbitrage is Minimal and Accounts Maxed Out
This one is a little more complicated to wrap your brain around, but let me see if I can explain it well. If your current marginal tax rate is 33%, you may have the choice to contribute either $15,000 to a tax-deferred account or pay $5,000 in tax and contribute $10,000 to a Roth 401(k). That decision should be made simply based on the expected effective tax rate on the money when withdrawn in retirement. However, if your choice is putting $18,000 into a Roth 401(k) (maxing it out) or putting $18,000 into a tax-deferred traditional 401(k) PLUS $6,000 (the taxes saved by making the tax-deferred contribution) the equation becomes a little bit different. If you expect to withdraw the money at much lower rates (contributions at 33%, and most of the withdrawals at 0%, 10%, 15% and perhaps even 25%) then you're better off with the tax-deferred account. However, if you'll be withdrawing most of the money at 33% or slightly less (say 28%) then the Roth 401(k) would be better due to the effect of the tax drag on the accompanying taxable account.
When maxing out retirement accounts (and thus using taxable accounts), the “break-even” rate is slightly lower than it would otherwise be. That, of course, doesn't count the asset protection and estate planning benefits of a larger Roth. Obviously, super-savers who end up with a huge nest egg (and thus end up with a higher tax rate on withdrawals than on contributions) should also utilize a Roth 401(k).
Bottom Line: No Brainer, but hard to estimate future brackets
# 6 Placing the Asset with the Highest Expected Return in Roth
This one is actually one of my pet peeves. Lots of people flippantly say “Put your stocks into Roth and put your bonds into tax-deferred” in order to increase their Roth to tax-deferred ratio and to increase the amount of money they end up with. However, they seem to view this as some kind of a huge free lunch. It isn't a free lunch. It does have a higher expected return, but only because it is taking on more risk. If they actually tax-adjusted their asset allocation, it would be exactly the same whether the stocks are put in Roths or not, at least on a short-term basis. This is because a tax-deferred account is really just a Roth account PLUS a government-owned but investor-controlled investing account.
However, let's be real. Very few of us actually tax-adjust our asset allocation. It's a pain, plus it requires a lot of guesswork. So taking on more portfolio risk in order to boost the size of your Roth accounts probably, in reality, works pretty well, especially since most investors aren't sophisticated enough to really notice the risk, and those who are probably don't mind it as much. There are two kinds of risk anyway: shallow risk- that short-term volatility that “adult investors” ignore, and deep risk- the risk of actually losing your money, even in the long term, predominantly due to inflation, deflation, confiscation, and devastation. This is one way for a skittish investor to take more risk probably without noticing it much, making it easier to stay the course.
Over the long run, the effect of the larger “true Roth” (as opposed to the tax-deferred “false Roth” + government owned account) does provide a small free lunch, it just isn't anywhere near as large as most initially calculate it out to be when they ignore the tax-adjustment calculation on the initial asset allocation.
Bottom Line: Increases portfolio risk, but probably worth it for most investors
# 7 Funding a Roth 401(k) During Peak Earning Years
If you find your Roth to tax-deferred ratio is particularly low, if you expect to have a massive tax-deferred nest egg, or if you simply wish to give a really nice gift to heirs, you can fund a Roth 401(k) preferentially during peak earnings years. There's obviously a significant tax cost, but it does increase your Roth space.
Bottom Line: Significant tax cost
# 8 Do Roth Conversions
Roth conversions, like Roth 401(k) contributions, are obviously best done in low-income years, using money in a taxable account to pay any tax due. Many people do Roth conversions up to the top of the 12%, 22%, or 24% bracket in those years between early retirement and the start of a pension or Social Security. It can be smart for the investor himself, and not just his heirs, but it can also be expensive, especially if you pay tax a rate higher than you or your heirs would eventually pay.
Bottom Line: Significant tax cost
# 9 Max Out a Personal and Spousal Roth IRA Every Year
Some people think a backdoor Roth IRA might not be the right thing for them due to tax bracket issues. However, what they're forgetting is that they're not comparing a Roth IRA to a traditional IRA, they're comparing it to a taxable account. They're ineligible to deduct a traditional IRA contribution. So their choices are a taxable account, a non-deductible traditional IRA, and a Roth IRA. That's a no-brainer. Fund your Roth IRAs early and often.
Bottom Line: No brainer
Which of these 9 techniques are you using to expand your Roth accounts? Why or why not? Comment below!