Retirement Income

Backdoor Roths and beyond: The four camps who can benefit Roth IRA conversions can unlock serious savings, especially if you find yourself in one of these scenarios. Roth IRAs and their tax-free perks are pretty great—so great that in some scenarios, it can make sense to convert pre-tax dollars from traditional retirement accounts into post-tax dollars in a Roth IRA. This is what’s known as a Roth conversion. You’re effectively taking those pre-tax funds and telling Uncle Sam you’d rather pay taxes on them now in exchange for the benefit of tax-free and penalty-free withdrawals in retirement. And if you need the money earlier, the IRS requires only that you wait five years before withdrawing each conversion to avoid a 10% penalty. So who do Roth conversions appeal to in particular? Four types of people: High earners and the “backdoor” Roth conversion Recent retirees and unwelcome RMDs Early retirees and the Roth conversion “ladder” People experiencing temporary income dips High earners and the “backdoor” Roth conversion Did you know the IRS restricts access to Roth IRAs based on income? Shut the front door! Yes, if your income exceeds these eligibility limits, you can’t contribute directly to a Roth IRA. But as the saying goes, when one door closes, another door opens. A “backdoor,” more specifically. So if you make too much money, fear not – you can contribute indirectly to a Roth IRA via a Roth conversion widely known as a “backdoor” Roth. This entails contributing post-tax dollars first to a traditional IRA, then converting those funds to a Roth IRA. If you’ve never contributed to a traditional IRA before, pulling off a backdoor Roth can be simple, especially if you use Betterment. Open both a traditional and Roth IRA with us, fund the traditional, then convert those funds to your Roth IRA once they’ve settled. Done! If you have any existing traditional IRA funds, however, things get a little more complicated due to something called the pro rata rule. In short, you need to move any pre-tax dollars out of your traditional IRA(s) into an employer-sponsored retirement account like a 401(k) before you can use the account as a backdoor. This gets even more complicated if you have both pre- and post-tax dollars mixed together in your traditional IRA(s). Before going down the road of a backdoor Roth conversion, or any Roth conversion really, we highly recommend seeking the advice of a financial advisor, as well as a tax advisor in certain cases. They can help assess both your current situation and future projections. Recent retirees and unwelcome RMDs The IRS doesn’t let you keep funds in your traditional retirement accounts indefinitely. They’re meant to be spent, after all. So starting at age 73, annual required minimum distributions (RMDs) from these accounts kick in. RMDs aren’t inherently a bad thing, but if your expenses can already be covered from other sources, RMDs will just raise your tax bill unnecessarily. You can get ahead of this and lower your future amount of RMDs by converting traditional account funds to a Roth IRA before you reach RMD age. That’s because Roth IRAs are exempt from RMDs. And as an added benefit, you’ll minimize taxes on Social Security benefits and Medicare premiums later on in retirement. Just make sure you convert those funds before you turn 73, because once RMDs kick in, those amounts can’t be converted. Early retirees and the Roth conversion “ladder” If you want to retire early, even by “just” a few years, you very well might encounter a problem: Most of your retirement savings are tied up in tax-advantaged 401(k)s and IRAs, which slap you with a 10% penalty if you withdraw the funds before the age of 59 ½. A few exceptions to this early withdrawal rule exist, the biggest for early retirees being that contributions to a Roth IRA (i.e., not the gains you may see on those contributions) can be withdrawn early without taxes or penalties, in this specific order: “Regular” contributions made directly to a Roth IRA. As an aside, you can always withdraw these funds tax-free and penalty-free without waiting five years. Once you’ve burned through regular contributions, the IRS allows you to withdraw contributions that were converted from traditional 401(k)s and traditional IRAs! You won’t pay any additional taxes on these withdrawn contributions because taxes have already been paid. But withdrawn conversions (item #2 above) typically are still subject to a 10% penalty if withdrawn before 5 years. Think of this rule as a speed bump in an otherwise swift shortcut. So what does all of this mean for early retirees? Starting five years before they plan on retiring, they can create a “ladder” looking something like the table below (note: dollar amounts are hypothetical). They convert funds each year, pay taxes on them at that time, then withdraw them five years later 10% penalty-free and sans any additional taxes. Time Amount converted Amount withdrawn Source of withdrawal 5 years pre-retirement $40,000 $0 N/A 4 years pre-retirement $40,000 $0 N/A 3 years pre-retirement $40,000 $0 N/A 2 years pre-retirement $40,000 $0 N/A 1 year pre-retirement $40,000 $0 N/A Retired early! 🎉 Year 1 of retirement $40,000 $40,000 5 years pre-retirement Year 2 of retirement $40,000 $40,000 4 years pre-retirement Year 3 of retirement $40,000 $40,000 3 years pre-retirement Year 4 of retirement $40,000 $40,000 2 years pre-retirement Year 5 of retirement $40,000 $40,000 1 year pre-retirement Etc. Etc. Etc. Etc. People experiencing temporary income dips Say you find yourself staring at a significantly smaller income for the year. Maybe you lost your job. Maybe you work on commission and had a down year. Or maybe you had a big tax writeoff. Whatever the reason, that dip in income means you’re currently in a lower tax bracket, and it may be wise to pay taxes on some of your pre-tax investments now at that lower rate compared to the higher rate when your income bounces back. Watch out for potential Roth conversion pitfalls Each of these scenarios requires careful tax planning, so again, we recommend working with a trusted financial advisor and/or tax advisor. They can help you avoid the most common Roth conversion mistakes and take full advantage of this post-tax money maneuver. Our CERTIFIED FINANCIAL PLANNER™ professionals are here to offer on-demand guidance.

Traditional vs. Roth: Should you take your tax break now, or later? Picking up where the standard guidance leaves off There can be endless decisions to make when investing. Chief among them: Whether to save for retirement through a traditional IRA and/or 401(k), or the Roth variety. With traditional accounts, you typically invest with pre-tax money, then pay taxes on withdrawals later in retirement. This lowers your taxes today and frees up more money to invest. With Roth accounts, you contribute money that's already been taxed, then enjoy tax-free withdrawals once you turn 59½, with no required minimum distributions. When it comes to which is better, here’s the advice you’ll often hear: Traditionals make more sense if your current tax bracket is higher than where you expect it to be in retirement. And vice versa with Roths. It's a start, but not always helpful in practice. Tax brackets can be confusing, for one, and nobody knows what they'll look like decades from now. People's incomes also ebb and flow with age, as do their tax brackets. Luckily, data from the U.S. Bureau of Labor Statistics can help us eyeball these shifts and plot out when each account type tends to shine brightest. The upward and downward slopes of spending When we look at American's average spending by age, we see it often peaks in middle age and declines as we approach our traditional retirement years. Connecting the dots, this means that traditional contributions often make more sense during the middle portion of workers’ careers. They’re likely earning and paying more in taxes than they will in retirement, so it makes sense to shift some of that tax obligation to a lower bracket down the road. For those with lower incomes, pairing those tax-deductible deposits with the standard deduction can also help squeeze more of their taxable income into the 12% tax bracket. The next bracket takes a big step up to 22%. As one’s income rises, however, another wrinkle may come into play. The IRA income limit exception If your income grows to a certain point (see the table below), you’ll face one of those so-called “champagne problems”: the tax deductions of a traditional IRA will begin to phase out, meaning it’s Roth or nothing if you want at least a partial tax break. Earn even more, and your Roth access will eventually dry up too, although there’s a handy “backdoor” option that’s worth checking out. A 401(k), as a side note, has no income restrictions for either contribution type. 2026 IRA income limits Traditional IRA* Modified Adjusted Gross Income (MAGI) Roth IRA Modified Adjusted Gross Income (MAGI) Full tax deduction $0-$79,000 (single) Full contribution $0-$149,999 (single) $0-$126,000 (married) $0-$235,999 (married) Partial tax deduction $79,001-$88,999 (single) Partial contribution $150,000-$164,999 (single) $126,001-$145,999 (married) $236,000-$245,999 (married) No tax deduction** $89,000 and up (single) No contribution $165,000 and up (single) $146,000 and up (married) $246,000 and up (married) *If covered by a retirement plan at work **Anyone is eligible to make taxable contributions to a traditional IRA Source: IRS This is why blanket statements like “Roths are better” don’t hold much water. The decision boils down to your personal income situation, and that’s subject to change. With Betterment, however, our Forecaster tool does much of the work for you. Simply scroll down to its “How to save” section, and we’ll use your self-reported financial information to suggest not only the optimal order of retirement account types, but whether traditional or Roth contributions make more sense based on your projected future tax bracket. Just be sure to update your info as needed (raises, marital status, etc.) for the most accurate estimates. Now or later? Now that’s one less call to make The traditional vs Roth debate will likely rage on for years. But between content like this, and tools like Forecaster, we do our best to help you quickly clear this common investing hurdle. If your income is trending anything like the averages above, traditional deposits may make more sense, but the advantage will be slight, and it never hurts to hedge. Having both Roth and traditional funds gives you more flexibility when managing your income in retirement. Plus, you can spend less time stressing over the two, and more time building momentum toward your goal.

How to manage your income in retirement An income strategy during retirement can help make your portfolio last longer, while also easing potential tax burdens. Retirement planning doesn’t end when you retire. To have the retirement you’ve been dreaming of, you need to ensure your savings will last. And how much you withdraw each month isn’t all that matters. In this guide we’ll cover: Why changes in the market affect you differently in retirement How to help keep bad timing from ruining your retirement How to decide which accounts to withdraw from first How Betterment helps take the guesswork out of your retirement income Part of retirement planning involves thinking about your retirement budget. But whether you’re already retired or you’re simply thinking ahead, it’s also important to think about how you’ll manage your income in retirement. Retirement is a huge milestone. And reaching it changes how you have to think about taxes, your investments, and your income. For starters, changes in the market can seriously affect how long your money lasts. Why changes in the market affect you differently in retirement Stock markets can swing up or down at any time. They’re volatile. When you’re saving for a distant retirement, you usually don’t have to worry as much about temporary dips. But during retirement, market volatility can have a dramatic effect on your savings. An investment account is a collection of individual assets. When you make a withdrawal from your retirement account, you’re selling off assets to equal the amount you want to withdraw. So say the market is going through a temporary dip. Since you’re retired, you have to continue making withdrawals in order to maintain your income. During the dip, your investment assets may have less value, so you have to sell more of them to equal the same amount of money. When the market goes back up, you have fewer assets that benefit from the rebound. The opposite is true, too. When the market is up, you don’t have to sell as many of your assets to maintain your income. There will always be good years and bad years in the market. How your withdrawals line up with the market’s volatility is called the “sequence of returns.” Unfortunately, you can’t control it. In many ways, it’s the luck of the withdrawal. Still, there are ways to help decrease the potential impact of a bad sequence of returns. How to keep bad timing from ruining your retirement The last thing you want is to retire and then lose your savings to market volatility. So you’ll want to take some steps to try and protect your retirement from a bad sequence of returns. Adjust your level of risk As you near or enter retirement, it’s likely time to start cranking down your stock-to-bond allocation. Invest too heavily in stocks, and your retirement savings could tank right when you need them. Betterment generally recommends turning down your ratio to about 56% stocks in early retirement, then gradually decreasing to about 30% toward the end of retirement. Rebalance your portfolio During retirement, the two most common cash flows in/out of your investment accounts will likely be dividends you earn and withdrawals you make. If you’re strategic, you can use these cash flows as opportunities to rebalance your portfolio. For example, if stocks are down at the moment, you likely want to withdraw from your bonds instead. This can help prevent you from selling stocks at a loss. Alternatively, if stocks are rallying, you may want to reinvest your dividends into bonds (instead of cashing them out) in order to bring your portfolio back into balance with your preferred ratio of stocks to bonds. Keep an emergency fund Even in retirement, it’s important to have an emergency fund. If you keep a separate account in your portfolio with enough money to cover three to six months of expenses, you can likely cushion—or ride out altogether—the blow of a bad sequence of returns. Supplement your income Hopefully, you’ll have enough retirement savings to produce a steady income from withdrawals. But it’s nice to have other income sources, too, to minimize your reliance on investment withdrawals in the first place. Social Security might be enough—although a pandemic or other disaster can deplete these funds faster than expected. Maybe you have a pension you can withdraw from, too. Or a part-time job. Or rental properties. Along with the other precautions above, these additional income sources can help counter bad returns early in retirement. While you can’t control your sequence of returns, you can control the order you withdraw from your accounts. And that’s important, too. How to decide which accounts to withdraw from first In retirement, taxes are usually one of your biggest expenses. They’re right up there with healthcare costs. When it comes to your retirement savings, there are three “tax pools” your accounts can fall under: Taxable accounts: individual accounts, joint accounts, and trusts. Tax-deferred accounts: individual retirement accounts (IRAs), 401(k)s, 403(b)s, and Thrift Savings Plans Tax-free accounts: Roth IRAs, Roth 401(k)s Each of these account types (taxable, tax-deferred, and tax-free) are taxed differently—and that’s important to understand when you start making withdrawals. When you have funds in all three tax pools, this is known as “tax diversification.” This strategy can create some unique opportunities for managing your retirement income. For example, when you withdraw from your taxable accounts, you only pay taxes on the capital gains, not the full amount you withdraw. With a tax-deferred account like a Traditional 401(k), you usually pay taxes on the full amount you withdraw, so with each withdrawal, taxes take more away from your portfolio’s future earning potential. Since you don’t have to pay taxes on withdrawals from your tax-free accounts, it’s typically best to save these for last. You want as much tax-free money as possible, right? So, while we’re not a tax advisor, and none of this information should be considered advice for your specific situation, the ideal withdrawal order generally-speaking is: Taxable accounts Tax-deferred accounts Tax-free accounts But there are a few exceptions. Incorporating minimum distributions Once you reach a certain age, you must generally begin taking required minimum distributions (RMDs) from your tax-deferred accounts. Failure to do so results in a steep penalty on the amount you were supposed to take. This changes things—but only slightly. At this point, you may want to consider following a new order: Withdraw your RMDs. If you still need more, then pull from taxable accounts. When there’s nothing left in those, start withdrawing from your tax-deferred accounts. Pull money from tax-free accounts. Smoothing out bumps in your tax bracket In retirement, you’ll likely have multiple sources of non-investment income, coming from Social Security, defined benefit pensions, rental income, part-time work, and/or RMDs. Since these income streams vary from year to year, your tax bracket may fluctuate throughout retirement. With a little extra planning, you can sometimes use these fluctuations to your advantage. For years where you’re in a lower bracket than usual–say, if you’re retiring before you plan on claiming Social Security benefits–it may make sense to fill these low brackets with withdrawals from tax-deferred accounts before touching your taxable accounts, and possibly consider Roth conversions. For years where you’re in a higher tax bracket, like if you sell a home and end up with large capital gains–it may make sense to pull from tax-free accounts first to minimize the effect of higher tax rates. Remember, higher taxes mean larger withdrawals and less money staying invested.