One question I have been asked a lot lately is, “how much should I have in Roth IRAs?” Or a more specific question, “What is the ideal mix between tax-deferred, tax free and taxable assets?”
The perfect mix of dollars in retirement accounts will be unique to everyone, but I believe it should be a priority for everyone to have some investments in Roth investment vehicles for the enormous benefits they can provide later in life.
Knowing that there is no perfect answer for everyone, I think that a third (33%) or investable assets is a number that federal employees could achieve. Now let’s get to the reasons behind the number.
Pay taxes strategically
One might think that the ideal scenario would be to have all of your investments be tax-free in retirement, but that wouldn’t be correct. Here’s why – in order to have all of your investments in Roth IRAs, it means you had to pay taxes on all of your income to fund them. And paying taxes on all your income during your working years would mean that in retirement you would have little to no taxes to pay. This may sound ideal to some, but if you aren’t paying any taxes then that means that you paid too much in previous years.
An example of why you’d want to pay taxes in retirement would be someone who paid 24% taxes on their income during their working years and then in retirement has a FERS annuity and Social Security income and is in the 12% tax bracket. Ideally this person would have had some tax-deferred investments that could be withdrawn while in the 12% tax bracket, instead of having paid 24% before retirement.
While there are other benefits to Roth IRAs, one of the main thoughts behind them is that you want to pay taxes while you are in the lowest tax bracket.
Roth tax-free advantages
Tax-free assets can prevent you from falling into higher IRS and Medicare brackets.
Let’s look at an example of how advantageous it can be to have access to income tax-free money in retirement.
- Joe and Jane Federal have taxable income of $70,000 which is comprised of their FERS annuity and Social Security. They are in the 12% federal income tax bracket which goes up to taxable income of $89,450 (in 2023). They will never be in a lower tax bracket than 12%. They need approximately $25,000 of additional income from their investments. Joe and Jane could withdraw $19,450 from their tax-deferred investments (TSP and IRAs) and then take the rest from their tax-free investments to avoid moving into the 22% tax bracket.
This is just one example of the flexibility that tax-free investments can provide. Take a peek at the federal income tax brackets to see where all the breakpoints are and how this might be a fit in your situation.
Similarly, with regards to Medicare, withdrawing tax-free income can help avoid IRMAA (Income-related monthly adjustment amount) surcharges. These are imposed on Medicare part B premiums for individuals who have MAGI above $97,000 and married couples who have MAGI above $194,000. Please note that MAGI is different than taxable income. Roth distributions are not considered taxable income, nor are they considered in the MAGI calculation for IRMAA, therefore Roth distributions could help you stay under the IRMAA threshold. The part B adjustments start at $66 a month ($91k single and $182k married) and I have seen a single federal retiree pay an adjustment of $363 a month. Federal employees, especially high earning feds need to be aware of IRMAA thresholds for two reasons:
- A higher retirement income can cause you to incur Medicare surcharges.
- Doing Roth conversions can add to your taxable income and cause you to incur surcharges.
Federal employees who choose not to take Medicare Part B won’t have to worry about IRMAA, however.
The two other significant benefits of the Roth IRA are that they pass income tax free to beneficiaries, and there are no RMDs. These two benefits are a big factor in funding Roth accounts.
So how much should a retiree have in Roth accounts?
If I were to pick a percentage for federal employees, I believe one third would be a good goal. It will never be 100% because all TSP matching goes to traditional TSP and as I have mentioned before there are definitely times that it makes sense to take the tax deduction for traditional TSP.
I believe that having 1/3 of retirement income in income tax free accounts would provide adequate flexibility for distributions in retirement. Obviously, any amount above a third would provide more access to tax free retirement distributions.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.