When Does It Make Sense to Invest in a Roth IRA Account?

For many years, I’ve been hearing people tout the benefits of a Roth account and it never made any sense to me.

Formulas for Roth IRA vs 401k

To wit, suppose you have $1.00 to invest and you are currently taxed at some tax rate, \(T_w\), (where \(w\) means working) and that you expect to be taxed at a different tax rate \(T_r\) at retirement. That means that you have two choices.

  1. If you invest in a 401k, a tax-deferred account, you pay no taxes now, but will be taxed at \(T_r\) when you withdraw the funds during retirement.
  2. Alternatively, if you invest in a Roth IRA, you pay taxes now at rate \(T_w\), but pay no taxes when you withdraw the funds during retirement.

The growth for the next \(n\) years is represented by \((1+G_0) \cdot (1+G_1) \cdot (1+G_2) \cdots (1+G_{n-2}) \cdot (1+G_{n-1}) \cdot (1+G_n)\) and it is the same whichever way you invested. So, your balance at the end of \(n\) years will be either: \[B = (1-T_w) \cdot (1+G_0) \cdot (1+G_1) \cdot (1+G_2) \cdots (1+G_{n-2}) \cdot (1+G_{n-1}) \cdot (1+G_n)\] or \[~~~~~~B = ~~~~~~~~~~~~~~~~~~(1+G_0) \cdot (1+G_1) \cdot (1+G_2) \cdots (1+G_{n-2}) \cdot (1+G_{n-1}) \cdot (1+G_n) \cdot (1-T_r)\]

Clearly, if you expect your taxes in retirement to be lower than they are now, you’re better off investing in a 401k, not a Roth IRA.

And that’s where my understanding stood until just recently.

When it does make sense to invest in a Roth IRA

Suppose you have been investing wisely for your entire working career and have amassed a small fortune, let’s say, $1,000,000.00 in your 401k and you retire gloriously at the age of 65. If you were born in 1960 or later, you will be required to take RMDs (Required Minimum Distributions) at the age of 75.

Your RMD is calculated by multiplying your balance by factor from an IRS table which essentially is \(1/L\) where \(L\) is your remaining life expectancy. The older you get, the fewer years remain and the denominator gets smaller and your RMD proportion gets bigger.

Now, your 401k balance will continue to grow (if you don’t withdraw anything) for the next 10 years, and if it grows at say, 9.13%, the geometric average rate of the S&P 500 for the last 40 years, you’ll amass a somewhat larger fortune of $2,396,611.37, which is great. What isn’t so great is that your balance will have grown so much and your first RMD at age 75 will be 1/24.6 of your principal, for a total of $97,423.22, and that in all likelihood just might push you into an unexpectedly high tax bracket (it could also trigger IRMAA surcharges).

What to do?

The thing to do is to reduce your RMD amounts as much as possible now and you can do that by doing a 401k to Roth IRA rollover. You’ll pay regular income tax on the rolled over amount now, but once it’s in the Roth IRA, it’ll grow tax-free. N.B.: note that there is a “Roth IRA 5-Year Rule” that you’ll want to look into: your growth or dividends are not tax-free until after the 5 years have elapsed (your contribution or conversion is immediately tax-free, however, so if you must withdraw some funds, withdraw those first).

Sounds simple. How much should you roll over? It depends on your other income streams (Social Security, dividends, other withdrawals or income, etc.) and how much the rollover amount will increase your taxes. I encourage you to model your own particular situation before blindly doing a rollover.

Are we done?

Nope, one more thing: tax withholding on the rolled-over amount. You have two options:

  1. You have the option of doing a “direct rollover” in which case there is no mandatory Federal tax withholding, though, of course, you’ll have to pay that tax come April 15th. And depending on what state you live in, you may have mandatory withholding of state income tax.
  2. The other option is a “60-day indirect rollover” where a check is sent to you or deposited directly into your bank account, and then you have 60 days to move those funds into a Roth IRA. For this kind of rollover, the Federal government withholding is 20% (and depending on your state, there may be more). But you can make up those withheld amounts with external funds, so that you can effectively roll over the entire amount.

Which should you pick? It depends on your state. In my own personal case, in the state where I live, if I don’t withhold the state income taxes, there is a penalty if I don’t pay quarterly estimated taxes throughout the year. So for me, it made sense to do a 60-day indirect rollover. Your mileage may vary.