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!
do think having your roth starting at an early age 100% in stocks is prudent because you might never have to touch it so you have 30 plus years of growth. And we know over 30yrs STOCKS BEAT BONDS almopst 100% of the time
and its usually the last nest egg you would touch if you needed those dollars in retirement
I opened roth iras for my three kids at about age 12. EVERY penny in stock index funds
Great idea to fund any ret plan in January for faster growth
Good review of roth space. We maxed our Roth IRA during the first week of Jan this year and, in the same spirit, will have maxed Roth TSP by the end of this month. I am starting my Anesthesiology residency next month. Two questions: can someone confirm that I am not eligible to defer any more salary this year to 401 (k)/3 (b), particularly with my new employer, since I will have hit my 18k max with TSP this month? Second, how does one approach the roth ira (backdoor, or not) during the last year of training, i.e. half year’s worth of resident and staff salary each? Thanks WCI and community.
Your first question is plan dependent. Check with your plan/HR/employer. In your case, the TSP for military folks has an $18K max if you’re under 50. I believe civilian folks get a match, so make sure you get your entire match, whatever the rules are on that.
Your second question is it depends. If you think you’ll be close to or over the income limit, go through the backdoor.
Thanks, I’ll check in with the plan administrator about additional employee contributions, given the previously maximized TSP.
The hospital’s employer contribution is described as a percentage of total pay determined by age and longevity without regard to employee contribution: not a match but a contribution defined by employee characteristics.
For W-2 employees the most effective is the mega backdoor Roth from after-tax contributions to their 401k/403b plans. Survey shows 40% of people actually have such a plan.
That would have been a good one to include. Doh!
Although I suspect that 40% number is far lower for docs.
I admit I don’t get #4, mainly because I have a big tax-deferred account, and I can’t figure out why I should put bonds in taxable rather than tax-deferred. Bonds are horribly tax-inefficient, and muni bonds have higher ER’s, risk of default, and other issues (you have to pay state taxes, etc.), so why would I want them there?
I use Roth for relatively tax-inefficient assets with higher return (REITS > small value).
If you have a huge tax-deferred account, it’s probably not a big issue either way. Same with me. I’m almost 100% tax protected.
Only munis for me on taxable acct
The default rates are miniscule on a A rated or better but I am diversifying with different states
Christie is an sob
I plan to start a spousal Roth IRA next year (I have one of my own), but my wife is a recent immigrant to the US with borderline English skills and worse understanding of finances. Is there any reason to be cautious about setting up a spousal Roth IRA if they wouldn’t be able to manage it themselves? We file jointly on taxes and she has negligible income at this point.
Thanks!
She can always hire somebody to help.
I am sure you can manage it for her. At least that is my plan. It does not require maintenance anyway.
Do you plan on divorcing your wife? If not, then just set it up and run it all yourself. Whats hers is yours and whats yours is hers…although my wife and I have names on different accounts we just consider it all one big retirement account for both of us…Even if you get a divorce, 50% is entitled to each spouse although these things are often negotiated differently. I see no downside. If you have the money shelter it.
No more than 53k can be put into 401k/Roth 401k with profit sharing plan between employee deferral of 18k, employer match, and employer profit sharing? If all of the above is maxed to 53k then the Mega Backdoor Roth is unavailable?
That’s right.
I’m a W2 employee making around $350k/yr. I do the back door Roth IRA for my spouse and me. I have been deferring the max into the company’s 401k non-Roth. We expect our retirement tax bracket to be lower than now (and move to a state with no income tax). I have the option of Roth 401k (any or all). I’m not sure I see an advantage to doing this. Maybe #5 and #7? Any thoughts? Should I split the difference? Thanks,
I’m not seeing much advantage to you doing a Roth 401(k) either during your peak earnings years. You’re getting some Roth via your backdoor Roths and perhaps you can do Roth conversions later.
Thanks a lot. That’s what I was thinking.
EXCELLENT (and balanced) quick summary of Roth options!
If the only tax deferred account that I have is a 401K/Profit sharing plan at my current employer, during a down year can I transfer a part of it to a roth, or does the entire account have to be transferred?
You can convert just part of it without a problem. However, your plan has to allow in-service withdrawals and most don’t. Read your plan document.
Jim,
Thanks so much for giving some more insight into usage of Roth spaces. As a psychiatry resident who is going to be in the lower quartile of physician income AND as a prodigious saver (33% gross income savings rate so far 2 years into my residency), I had a feeling in the back of my head that I used prefer Roth over Traditional.
And I think your words have put my thoughts down fairly well. And as someone who has liked Ed Slott as well as looking at the current lower tax rates…and combined with the less than optimal insolvency of SS, I feel that paying taxes now is better than some 30-40 years into the future.
Luckily I have access to a Roth 403b at my residency and have been putting it to good use (if only me fellow residents knew about that).
If you’re a resident, paying taxes now is almost surely the right move.
Thanks for the great overview! Followup question to #4. Would the asset allocation decision change at all if you know that you are working with a Stealth IRA? So if the beneficiary has yet to hit double digit age, does it make sense to diversify and put anything in Total Bond? Right now, the whole balance is sitting in VFINX. Everyone is screaming doomsday (7th year of bull, the correction is coming, etc.), does it even matter if the beneficiary’s RMD won’t be there for at least 60 more years?
Not sure that using an HSA as a stealth IRA would change your asset allocation in any meaningful way.
I agree you can be very aggressive when the money isn’t needed for decades.
My mistake – I meant to say “Stretch” IRA.
Got me re-thinking things WCI. For so long, I have been following the advice from Bogleheads.org and the recommend reading books in that our ROTH IRAs and traditional 401ks are 100% invested in bonds. Additionally, due to the size our our taxable account (approx. $1 mil), I have additional bonds in the Vanguard CA intermediate term tax-exempt adm fund (VCADX).
FWIW, we max our 401ks and ROTHs, and have about $72k in cap losses. Would it be worth it to switch our our ROTHs and traditional 401ks to stocks, and additionally sell some stocks for bonds in our taxable account?
At the same time, I am trying to decide if it is even worth considering the ROTHs as a separate allocation with their own time horizon since that is $ to be used last, if at all.
If I implement this and sell stocks to buy more VCADX in our taxable, it seems like a lot of work if interest rates rise.
I don’t think it would be worth paying much taxes to switch. Hard to say if you could use those losses in a better way later than to do a switch like this.
But you can always make changes with new money/dividends etc at no tax cost.
Dr. Dahle:
Would you please explain more about “…Roth- including better asset protection in most states…”?
My understanding is that if you rollover or convert ERISA protected assets like 401k, 403b into Roth IRA, you loss the creditor/law suit protection (in some states,I guess). so why a larger Roth is good for doctors who are so vulnerable to lawsuits?
thanks
Asset protection is all state specific. But in general, putting money into a Roth account provides better asset protection than an equal amount of money into a taxable or a tax-deferred account- since there is more after-tax money there.
I will be beginning residency in June and I can’t seem to understand the retirement accounts and how to start contributing. Should I be opening a Roth IRA on my own or does my employer have to be involved in this process?
Go see HR when you start and ask for the 401k or 403b summary plan document and any other info they can give you. You may still choose just to do a Roth IRA instead.