How Roth accounts can be used as a tool for retirement and legacy planning

Roth accounts have been a popular way for Americans to generate tax-sheltered investment growth for more than 20 years, both as Roth IRAs and Roth 401(k)s. But following the 2017 Tax Cut and Jobs Act (TCJA), which broadly reordered tax brackets and shifted many Americans into lower categories, Roths may now work better than ever as a tool for saving for retirement, estate planning and legacy.

Established in 1997, Roth accounts differ from traditional IRA and 401(k) accounts, which allow tax deductions on contributions, with taxes to be paid when you withdraw funds in retirement. With a Roth, contributions are made with after-tax dollars, and so, in a sense, the taxes on retirement withdrawals are prepaid.

This makes Roths appealing to investors who expect to be in a higher tax bracket when they begin making withdrawals than where they are currently (such as younger professionals in an earlier stage of their career), and that’s where the TCJA comes in.

Under that new law, marginal rates across several income levels were lowered, with some brackets removed completely. For instance, a single filer earning between $93,700 and $157,500 saw rates fall to 24 percent in 2018 from 28 percent in 2017 as a result of the change. Barring additional legislation, the TCJA will sunset after 2025, at which point tax rates would revert to a higher level.

“It is hard to say anything with certainty, but I have a hard time seeing those brackets going lower over the next 10 or 20 years,” says Griffin Geisler, a wealth planning consultant at RBC Wealth Management–U.S.

As a result, Geisler has been focusing on Roths. “I do have a lot of conversations around it,” he says. “Those tax brackets are something we’ll use to illustrate where clients might have an opportunity to take some income at lower rates now before they go up in the future.”

How to make best use of the Roth structure

To make the most out of a Roth account, one option is to contribute the full amount allowed each year. In 401(k) plans that allow Roth contributions, those limits for 2023 are $22,500 for investors under 50 years old, and $30,000 for those over 50. For Roth IRAs, however, the limits are significantly lower: $6,500 for those under 50, and $7,500 for over 50. At higher income levels, those limits decrease and eventually phase out.

An alternative way to benefit from the Roth structure is a Roth conversion, which involves transferring funds from a traditional IRA to a Roth, and paying the full tax on the conversion amount up front. There are no income limits on doing a Roth IRA conversion.

When to consider a Roth conversion

A Roth conversion may make sense for anyone who expects to be in a higher tax bracket in the future, but Geisler often sees a particular fit for people who have retired in their late 50s or early 60s and have seen their income drop as a result, but still have a few years before their IRA distributions begin by law at age 73.

“The fundamental thing with a conversion is that you do it in a year where you think your tax bracket is lower now than in a future year,” says Dean Deutz, a private wealth consultant with RBC Wealth Management–U.S.

Conversions may also make sense for investors who are further away from retirement, provided a sound strategy is employed. Determining the right amount to convert can depend on how much room an investor has in their current tax bracket. Investors must also consider the fact that they’ll have to absorb the upfront cost of paying income taxes on the full amount of the conversion, which can feel like a deterrent, Geisler says.

“Even though you know it’s the right thing to do and you know you’ll get a benefit out of it, just behaviorally and emotionally, it can be tough to pull the trigger on that,” says Geisler. “But from a number standpoint, we can show clients the benefit.”

Investors looking to convert a significant amount to Roth may opt to spread the conversions over a number of years, which can allow them to stay in a lower tax bracket year to year.

“The way we’d generally talk about Roth conversions is to do little ones up to the top of your current tax bracket,” says Deutz.

Other Roth benefits

Roth accounts can also provide tax diversification to a portfolio. Having after-tax funds available may give investors the flexibility they might not otherwise have if their investments were entirely held up in assets such as real estate, or accounts that would incur large penalties if funds are withdrawn early. Another benefit is that investors can begin taking Roth distributions as early as age 59-1/2 as long as your account has been open for five years. In addition, unlike with traditional IRAs, you do not have to take required distributions once you reach age 73.

The Roth structure also makes them ideal for helping to shape a family legacy, as they can be passed on to heirs without the heirs having to pay taxes on the account in the future.

“The impact it can have on the next generation is significant,” Geisler says.