High earners near retirement risk overpaying taxes with Roth 401(k)
Wealthy investors approaching retirement may be eroding their after-tax returns by blindly maximizing Roth 401(k) contributions at their peak earning rates.
High-income earners in their mid-fifties are routinely making a costly portfolio allocation error by funneling all their savings into Roth 401(k) accounts. Married couples earning low six figures are frequently locking in a 24% federal tax rate on contributions. This strategy ignores the high probability that their retirement withdrawals will be taxed at lower effective rates of 12% or 22%.
Because Roth accounts are funded with after-tax dollars, investors using this approach pre-pay the government at their highest lifetime marginal rate. Traditional pre-tax accounts operate inversely. High earners can deduct their contributions at 24% today and defer ordinary income tax until retirement, when their overall tax bracket typically compresses.
The calculation grows more intricate when integrating Social Security income. For married couples, provisional income falling between $32,000 and $44,000 triggers taxation on up to 85% of their benefits. If retirees hold exclusively Roth assets, they avoid required minimum distributions but have already sacrificed capital to excessive upfront taxes. Conversely, large RMDs from traditional accounts can unexpectedly push retirees into higher brackets.
A dual-account strategy resolves this friction. By retaining both pre-tax and Roth balances, investors create options to execute targeted Roth conversions during low-income gap years. These are the years between a worker's actual retirement date and the mandatory onset of RMDs. Converting assets during these windows allows retirees to pay taxes at the favorable 12% to 22% rates while precisely controlling their IRMAA surcharges.
The timing risk associated with these maneuvers is severe enough to warrant caution from prominent advocates of Roth accounts. "Three years away from retirement, five years away from retirement, anything less than eight years away from retirement and you're in a tax bracket where you're paying taxes...It makes absolutely no sense for you to convert from a traditional retirement account into a Roth retirement account because there isn't enough time for you to make up the taxes," said Suze Orman on her podcast.
