Can You Have Too Much Money In Roth? Four Reasons the Answer is Yes.
Roth accounts are one of the most beneficial tax-advantaged saving and investing tools available.
By allowing investors to pay taxes on their contributions, but then allowing earnings to grow completely tax-free, Roth accounts provide a way to excuse Uncle Sam from at least some portion of your money…forever.
And while the merits of using Roth accounts versus traditional tax-deferred investment vehicles are debatable depending on your personal tax circumstances, both now and when you make withdrawals, what isn’t debatable is the fact that virtually everyone prefers money that is sheltered from taxes over money that isn’t.
So, wouldn’t it be ideal to eventually have as much money as possible in Roth accounts?
Doesn’t it make sense to direct as much of your investments as reasonably possible into an account that will never be taxed again?
You’d think so, but there are a few reasons you should leave at least some portion of your investments in either taxable or tax-deferred accounts.
Let’s look at these scenarios to explain why.
1) You’re a Giver
If you have plans to donate money to charity, even as you begin drawing down your retirement accounts, having all your eggs in a Roth basket isn’t very tax efficient.
That’s because you won’t have any income to deduct the donation from, meaning you paid tax on your Roth contributions or rollovers, only to give it away later as a gift that could have been tax-free.
Come to think of it, it’s never very tax efficient to donate from a Roth account. You may choose to do so because you want to support a cause that’s important for you, but if you give from a Roth account then there could have been a better way.
There are a couple of ways to avoid this, however.
The first is quite logical. Just don’t convert everything to a Roth account.
If you have ongoing or future plans to make gifts to charity, leave that money in tax-deferred accounts so you can make those donations AND receive a tax deduction for your generosity.
A second option is to fund a Donor Advised Fund (DAF).
A DAF allows you to direct some portion of your assets into an account held by a third party (usually your investment brokerage) where it can be invested or directed to the charity of your choosing at your discretion.
You could receive a tax deduction when you place money into the DAF up to 60% of your adjusted gross income for cash donations and 30% for non-cash gifts.
Be aware, however, that gifts to a donor advised fund are irrevocable.
The tax deductions are only allowed because the money is no longer yours so be sure you’re ready before you make any donations.
2) Inheritance
In my opinion, Roth IRAs are the best way to receive an inheritance.
What’s not to love? Roth’s are received completely tax-free, heirs have ten years to withdraw the funds, and they can even invest the money in the account as they draw down the balance.
It’s like inheriting another Roth IRA.
However, I emphasized the word “receive” for a reason.
Just because your heirs might enjoy receiving their inheritance in the form of a tax-free Roth IRA, that doesn’t mean it’s the most tax-efficient way to bequeath assets to them.
Imagine for a minute that you are working hard on your goal of converting every penny you have to a Roth IRA. Let’s also assume that you won’t really need this money and plan to leave it to your kids one day as part of their inheritance.
These conversions are taxable, meaning you are effectively paying an amount equal to your marginal tax rate (your top bracket) for every dollar you move to a Roth.
So, if you’re in the 22% tax bracket and move $50,000 into a Roth, you’ll owe $11,000 in income taxes for the conversion.
Now also imagine that your kids are in the 12% tax bracket.
If you left the money in a tax-deferred space, like a Traditional IRA, then they would only pay $6,000 for every $50,000 they remove from the inherited IRA.
In other words, they’re inheriting 10% less because you were generous enough to take the tax hit “on their behalf”.
Oops.
On the other hand, you could delay conversions while your heirs are in low tax brackets, only to see them excel in their careers and earn incomes that run above and beyond the 22% bracket you didn’t want to convert at.
The truth is it’s hard to hit a moving target which is why I suggest that you manage your estate for you and let your heirs figure out the tax details after you’re gone.
Sure, there are things you can do to make managing your estate much easier, but don’t let the tail wag the dog here.
It’s your money. You should treat it that way for the rest of your life.
3) You’ll Get Sick (Probably)
Currently, tax laws allow you to deduct up to 7.5% of your adjusted gross income for medical expenses each year but this deduction will be of little value if you don’t have any taxable income to report.
Estimates show that the average person can expect to spend about $315,000 for medical care after age 65.
Even if you only spent half of that, these deductions could provide considerable tax savings.
Additionally, you could direct medical savings into a Health Savings Account which is a super tax-efficient way to cover medical costs.
HSAs allow for tax-free contributions, earnings, and withdrawals if the funds are used for a qualified medical expense, meaning those dollars are never taxed.
Having a triple-tax-advantaged HSA will save you even more on your taxes than a Roth account.
So, if you have an adequately funded HSA, maybe you won’t have to worry all that much about leaving money out of your Roth to pay for medical expenses as you age.
Even if you don’t have access to an HSA, you’d be better off financially if you had taxable income that you could deduct these expenses from.
4) Overpriced Conversions
Since you are reading about Roth accounts you are probably very aware that the optimal decision to contribute to a Roth or Traditional tax-advantaged account is dependent on your tax rate when you make contributions versus when you make withdrawals.
If you are in a lower tax bracket now than you expect to be in during the drawdown phase of your account, you should contribute to a Roth so you can pay taxes on the contributions which will be lower now than the taxes you would have to pay on your withdrawals later.
The inverse is true if you are in a higher bracket now than you expect to be in during retirement.
If your tax bracket is the same when you make contributions and withdrawals, then the standard logic is that it doesn’t matter which account you use.
And that’s almost right.
It’s true that if you compare a contribution and withdrawal of any amount and levy the same tax rate against it (either at the time of contribution or withdrawal), you will net the same amount.
For example, let’s assume you have $1,000 that you want to put into an IRA that you will withdraw one year from today. It will earn 5% interest and will be taxed at 22%.
If deposited into a Roth IRA, you will contribute $780 to the IRA (because 22% of the contribution is taxed), earn $39 as a 5% return, meaning you will net $819 after taxes.
If you use a Traditional IRA, you will contribute the full $1,000 (taking advantage of the tax deferred contributions), earn $50 at a 5% return, pay $231 in tax (22% of $1,050), for a net total of $819.
Yep. Like we said, it’s the same result. If the tax rate is the same, your net result is the same.
There’s just one problem. The tax rates are probably not going to be the same.
You see, the United States uses a progressive tax system for income taxes. This means the higher your adjusted gross income, the more you will owe as a percentage of that income in taxes.
Depending on how you file, the first dollars you earn are taxed at 10%. Every dollar above that will be taxed at 12% until you reach the next income bracket and start paying 22%.
This goes on and on through 24%, 32%, 35%, and 37% tax brackets.
In retirement, you aren’t likely to have much in the way of earned income meaning your IRA or 401(k) withdrawals may be among the first dollars taxed at those lower brackets.
This means Roth contributions you might have made at 22%, thinking you were in the lowest bracket you’ll see, could dodge a 12% tax when you make your withdrawal. Oops.
Granted, those lower brackets are not exceptionally large, so you probably wouldn’t be missing out on a significant savings but it is worth noting.
Also, this shouldn’t stop you from converting out of tax-deferred accounts if you expect to have significant Required Minimum Distributions (RMDs) once you reach that age.
If you are going to make large withdrawals that will push your AGI into higher brackets, then it will make sense to continue converting those sums to an extent.
But maybe not everything.
Other Than That
It’s not every day that one ponders when a Roth isn’t the best option. Like I said from the start, tax-free money is hard to beat.
But, even though I’m a big fan, Roth is not always the answer. Keep these things in mind as you’re making contributions to your retirement accounts.
For more about Roth accounts, check out our Roth Playlist on our YouTube channel or flip through some of our Roth posts on the website.
