Money expert Clark Howard radiates enthusiasm whenever he talks about Roth IRAs and Roth 401(k)s as retirement options.
“I have been the man from Roth forever,” Clark says. “I’m obsessed with the Roth as a way to save for retirement.”
There are few topics Clark enjoys more (Costco, maybe?).
But sometimes it’s good to remember why Clark loves Roth, not just how much he loves Roth. In a podcast (see video above), Clark sent a verbal love letter to the retirement option, underscoring the two primary reasons Roth retirement accounts are so powerful.
Table of Contents
- A Dollar Saved Is a Dollar Earned
- Math Trick: Roth Investors Save More for Retirement
- Clark Wants You To Consider Switching to Roth Contributions
1. A Dollar Saved Is a Dollar Earned
“The Roth IRA means a dollar saved is a dollar you’re going to have in retirement. Where in a traditional IRA or a traditional 401(k), a dollar saved is not a dollar,” Clark says. “It’s somewhere maybe 70 cents on the dollar or less.”
The reason why? Taxes.
As a reminder, the key difference between a traditional and a Roth retirement account involves taxes. You contribute to a Roth account with post-tax dollars, and you contribute to a traditional account with pre-tax dollars.
Traditional 401(k) and IRA contributions reduce your taxable income.
In plain English, if you contribute to a traditional 401(k) at work, your employer takes that money out of your paycheck. That money won’t be part of the total that appears on your W-2 (your taxable income for the year).
With a Roth, every dollar you contribute will be part of your taxable income on your W-2.
In retirement, assuming you don’t withdraw too early, you’ll be able to withdraw every dollar in your Roth account tax-free. That includes your initial contribution as well as your investment earnings.
When you withdraw from a traditional retirement account, you’ll owe income tax on every cent of profit your investments make as well as on your initial contributions. (After all, the IRS never got to tax you on that income originally.)
Quick Aside: Real Estate, Taxes and IRAs
You can be taxed on income if you hold private placement real estate inside your IRA.
Clark isn’t a fan of holding private equity real estate inside a retirement account. “You’re adding layers of complexity that are just too great” and taking away some of the tax advantages, he says.
These tax snags don’t apply to publicly traded REITs (Real Estate Investment Trusts), REIT index funds or real estate mutual funds.
Crucial Prediction: Taxes Will Rise in the Future
Clark is the last person you’d expect to gamble on his financial future — much less the financial future of his audience.
However, the Roth vs. traditional decision forces us all to take a risk. In many ways, you’re placing a bet on tax futures. Will they be significantly lower in the future? Relatively the same? Or significantly higher?
There is little doubt in Clark’s mind that taxes will be higher in the future than they are today. Assuming he’s right, that makes contributing to a Roth account an even more obvious choice.
“Tax rates in the United States today are unusually low by historical measures. And if you just want proof of that, we are bringing in far less in tax dollars than what we’re spending,” Clark says.
“Most of that spending doesn’t change depending on who’s in power because most of it is statutory. It’s for programs that are already ‘baked’ in for entitlements. And so ultimately the bill has to be paid. And it’s my belief that eventually, rather than the country going broke, we will be expected to pay more tax.“
2. Math Trick: Roth Investors Save More for Retirement
When it comes to investing for your retirement via a Roth IRA or 401(k), predictability is a big help.
“Effectively, people tend to put the same percentage of their pay into a retirement account whether they do a traditional 401(k) or a Roth,” Clark says. “Which effectively means you’re saving a lot more money.”
Let’s say you make $100,000. You put aside 10% of your income into a Roth 401(k) each year, or $10,000. Your friend makes the same salary but contributes to a traditional 401(k) instead.
The good news for your friend is that he or she will reduce their taxable income for the year to $90,000. However, your friend hasn’t really saved $10,000 for retirement. It’s $10,000 minus the income tax the person will owe when they withdraw.
Let’s say their effective tax rate when they withdraw the $10,000 is 20%. That means a $2,000 tax bill.
The $10,000 you invested in the Roth 401(k) won’t reduce your taxable income. But in retirement, you’ll have the full $10,000 tax-free.
Whether the tax rate is higher now or later, you’re effectively putting more money toward your retirement with the Roth version.
“So that’s where I’m underhanded, sneaky, deceptive, terrible,” Clark says with a smirk. “I’m using behavioral economics as a way to get you to save more money.”
It’s possible to contribute more if you’re using a traditional 401(k) or IRA. But there are 401(k) and IRA contribution limits. So if you’re contributing the maximum, Roth always trumps traditional in terms of effective dollars saved for retirement.
Clark Wants You To Consider Switching to Roth Contributions
Hopefully, you’re starting to understand why Clark loves Roth.
If you already contribute to a traditional 401(k) or IRA, Clark wants you to think about switching — even if you’re close to retirement.
“I want to tell you my obsession with Roths is that they’re so great because it’s an opportunity to have money grow tax-free and spend it tax-free,” Clark says.
“If you’ve been working at an employer for a while, they probably didn’t have a Roth 401(k) option when you started. But today, roughly 90% of companies that offer a 401(k) offer you the choice of traditional or Roth. And particularly if you’ve been at a place a while, you’ve been doing traditional all through the years, I want you — as long as you stay with them from this point forward — to do Roth.”
Clark’s Exception for the Wealthy
If your income places you in one of the highest tax brackets right now, Clark’s opinion of your current taxes versus your future taxes changes once you’re withdrawing in retirement.
If you’re in the 32% tax bracket in 2023 ($182,100+ in taxable income if you’re single and $364,200+ for married couples) or higher, “That’s when it starts to tip that maybe you should do traditional,” Clark says. “We’re talking about a tiny percentage of the population. We’re talking about doctors and lawyers.”
Consider Switching Your 401(k) Match to Roth
Until recently, any company 401(k) match automatically went into a traditional 401(k) plan.
That is, even if you contribute to a Roth 401(k), if your company offered a match, it still went into a traditional account and reduced your taxable income for the year. It also set you up for a tax burden in retirement, although it was worth it.
However, Congress passed a series of retirement account changes on the heels of the COVID-19 outbreak. Included in the laws are three big retirement account changes you may not know. Among them: it’s now legal for a company to grant you a 401(k) match into a Roth 401(k) account.
You have to ask for it. And not all 401(k) plan administrators are offering this new perk. But it’s just another way you can maximize your Roth 401(k) contributions and lower your tax bill in retirement.
Final Thoughts
Delayed gratification goes against the trend in the United States and the world at large this century.
In a society with same-day shipping and instant everything, it can be challenging to rewire our brains for something that’s years or even decades down the line.
However, when it comes to saving for retirement, Clark is emphatic that the pain of paying full freight in taxes now will be well worth the reward of withdrawing and spending your pile of retirement savings tax-free.
It could even be the difference between years of financial anxiety in retirement versus feeling comfortable and relaxed about your retirement funds.
