I'm confused: Should I pay tax now or later on my retirement savings - and from what funds?

By Beth Pinsker

The best Roth conversion strategy can be elusive when you get conflicting advice

Dear Fix My Portfolio,

I have access through work to an after-tax 401(k) contribution with an in-plan Roth rollover.

I am maxing out my pretax contributions and using the mega backdoor contributions. I have saved enough in my pretax retirement accounts when I retire, I will need to roll some over to Roth accounts to help minimize my required minimum distribution amounts and annual retirement income. Given that I plan on retiring early, I will have time to do this while in a lower tax bracket. I was recently advised to save money outside of a retirement account instead of in the backdoor Roth.

The theory is to use nonretirement funds to pay the taxes on the rollovers and let the Roth continue to grow tax-free. I am having trouble understanding why it is better to save outside the Roth for taxes when I could also use the Roth for taxes (or use the 401(k) for taxes). It seems like I will pay gains on the nonretirement accounts now while in a higher tax bracket, and if I use the mega backdoor Roth, I won't have to pay any gains and can still use the same amount for taxes. What am I missing? I'm looking for a second opinion.

Taxpayer

Dear Taxpayer,

What you're missing is that you're in a retirement marathon, and the strategy you're talking about measures in inches.

Try taking a step back and looking at the big picture. Guide your actions based on your goals, rather than the taxes involved. I have talked to a lot of experts over time about Roth conversions, and they always end up with the same conclusion: Don't let taxes drive your money-management decisions.

Roth conversions are when you take money in a pretax account like a 401(k), pay tax on it and then roll it directly into a Roth account that will grow tax-free. So you either pay tax now or later. This will be a choice you have to make a lot. Taxes are a factor in any financial decision, and you can do your best to minimize the amount you pay, but they should not be the driving force for what you choose to do.

Your goal seems to be to retire early. With that in mind, you want to focus most on maximizing your savings while you are still working. Everything about how you do this is going to be up for debate, and that can be confusing. You can get a second opinion, and a third, and they could all be different. One path could appear to be less today and turn out to be more down the road because tax law or your situation changes. None of the math is a sure thing. The only certain thing is that the government is going to get its taxes at some point - it's just a matter of when.

In today's economic climate, the theory behind what you're doing with mega backdoor Roth conversions and what you've been advised about paying the tax from cash savings is sound. The reasoning behind this is to maximize the amount of funds you can convert into a Roth account, which allows the growth to be tax-free from that point forward. Moving your money to a Roth also gives a tax advantage to your heirs. They will have 10 years to enjoy tax-free distributions and growth, and then they'll transfer the funds to a taxable brokerage account.

If you were to pay the tax due on a conversion with funds from the conversion itself, you'd simply have less to put into the Roth. If the whole goal of paying tax now is to get as much as possible into a Roth account, then you want to follow that through.

The same principle applies to what you're doing with mega backdoor Roth conversions. This is a complicated extra step that lets you put as much as you possibly can into a Roth account so that the growth will not be taxed in the future. You're taking a big bet that your tax rate will be lower in the future, and that Roth accounts will continue to offer these tax advantages.

It might seem like you're doing this for tax purposes, but your No. 1 priority is actually putting away as much as you possibly can while you're working in order to fund your early retirement. The tax code that you're taking advantage of is actually the 401(k) contribution limitation.

Most people think of the current $23,000 limit for workers - plus the $7,500 allowed for catch-up contributions for those 50 and older - as the end of the story. Most people don't even come close to hitting those amounts on a yearly basis. But there's another limit, which is $69,000 in 2024 (or $76,500 for people 50 and older). That is for employee plus employer contributions. If your employer gives, say, a 6% match, there's room left under that cap. With a mega backdoor Roth conversion, employees can make post-tax contributions to their 401(k) to the maximum, and then immediately roll the funds over to a Roth account, as long as the company allows in-plan conversions like yours does.

The real benefit of doing this is not necessarily the reduction of future taxes, but to help you put aside a significant amount for retirement. When you think about it that way, it's less confusing and you can have less doubt that you're doing it the "right" way. You're already ahead of the game just stuffing as much as you can into your retirement kitty.

One last thing to consider is the five-year rule. This only comes into play if you're younger than 591/2. If you're pushing as much as possible into Roth accounts because you're planning on retiring early and want access to funds without a tax penalty before you turn 591/2, then you want to make sure you're starting early enough that you have the account open for five years before you need to touch the money. If easy access is your goal, then saving more in a taxable brokerage may be more efficient for you.

Got a question about investing, how it fits into your overall financial plan and what strategies can help you make the most out of your money? You can write to me at beth.pinsker@marketwatch.com. Please put "Fix My Portfolio" in the subject line.

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-Beth Pinsker

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06-29-24 0915ET

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