Roth Advice Gone Wrong and Mandatory Roth Catch-Up Contributions in 2026

0:04Roth advice gone wrong and next year's mandatory Roth 401k contributions for higher earning workers over 50. That and more on this Saturday personal finance edition of Motley Fool Money.

0:19I'm Robert Brokamp and this week I have a conversation with my colleague Megan Brinsfield about investors considering a Roth account when it may not be the best choice. But first up, let's see what went on last week in money, starting with the Federal Reserve's third cut this year. At the meeting that concluded this past Wednesday, the divided Fed reduced the target for the Fed funds rate by a quarter of a percentage point. The vote was 9-3, with two votes for no change and one vote for a bigger cut. It was the first time in six years that three officials dissented. The market seemed pleased with the decision as the S &P 500 ended the day up 0.7%.

0:54But value stocks and small cap stocks did even better, and their combination was particularly powerful. Small cap value stocks gained 2.3 % on Wednesday, as measured by the performance of the iShares S &P Small Cap Value ETF, ticker IJS, which is also up 6.2 % since the start of November, compared to just 0.8 % for the S &P 500. For our next item, we turn to a classic year-end tip, and that is to take your required minimum distributions from your retirement accounts if you're 73 or older. Otherwise, you may pay a penalty of up to 25 % of the amount you should have taken. But another group of investors might also need to take RMDs, and those are owners of inherited retirement accounts.

1:38The rules governing these accounts have changed quite a bit over the past few years and got very complicated. So complicated that it's taken the IRS a while to issue official clarifications. So while they figured things out, the IRS gave some types of owners of inherited accounts a pass by not requiring withdrawals. But that reprieve ended this year. So if you inherited a retirement account, make sure you determine if you need to take money out in 2025, and if so, don't wait until December 31st, since it may take a few days for any necessary trades to settle and the cash to be distributed. Now, you may not have yet inherited a retirement account, but here's something that is very likely to happen.

2:17Someone will inherit your account one day. So please, please, please do your future heirs a favor and complete and update the beneficiary designation forms on your IRAs and 401ks. This will ensure that the money goes to the people that you want, they will get the money much faster, and they will likely be able to leave the money in the account longer, benefiting from more years of tax-advantaged growth. And now we turn to the number of the week, which is more than 30%. That's how much the NASDAQ 100 has dropped in every one of its down years since 1995, according to Ritholtz Wealth Management.

2:52However, there have been only five down years of the past 31, and three of them came in a row during the dot-com crash that began in 2000. Since 1995, the Nasdaq 100 has returned 15 % a year on average, compared to 11.1 % for the S &P 500, which, by the way, has declined by more than 30 % in a single year just once over the past three decades. Up next, when a Roth may not be right, when Motley Fool Money continues. When Johann Rall received the letter on Christmas Day 1776, he put it away to read later. Maybe he thought it was a season's greeting and wanted to save it for the fireside. But what it actually was, was a warning, delivered to the Hessian colonel, letting him know that General George Washington was crossing the Delaware and would soon attack his forces.

3:42The next day, when Rall lost the Battle of Trenton and died from two colonial Boxing Day musket balls, the letter was found, unopened in his vest pocket. As someone with 15 ,000 unread emails in his inbox, I feel like there's a lesson there. Oh well, this is The Constant, a history of getting things wrong. I'm Mark Chrysler. Every episode, we look at the bad ideas, mistakes, and accidents that misshaped our world. Find us at ConstantPodcast.com or wherever you get your podcasts.

4:21These days, you're likely hearing about the many benefits of Roth accounts, including from this very podcast, specifically our November 15th episode. But while tax-free Roth accounts have many charms, they're not the best choice for every investor. Here to talk about when the advice to Roth goes wrong is Megan Brinsfield, a certified financial planner, certified public accountant, and the president of Motley Fool Wealth Management, a sister company of The Motley Fool. And a quick disclaimer, this conversation does not constitute advice, so make sure to consult with your tax or wealth advisor to discuss any strategies.

4:53And with that said, welcome, Megan. Thank you so much, Robert. I'm happy to be here. Well, it's great to have you here. We're going to talk about some scenarios you've come across where someone is being, just how we say, just nudged to contribute toward a Roth account, but you think that perhaps it may not be the right move, starting with investors overlooking the adjusted gross income ripple effects. Tell us about that. Yes. So anytime you're making a Roth conversion, you're adding income to your AGI. And you may assume, of course, that if you add to your income, your tax rate will go up. But there are other impacts other than just your federal income tax bracket to consider.

5:37And primary among many retirees or soon to be retirees would be the consideration of how much Medicare costs. Medicare is based on your gross income. And so the higher your gross income is, the higher your premium will be. And you may think, oh, that's just when I turn 65 plus. But actually, the Social Security Administration looks back two years to your income at age 63 when you start paying at age 65. So the real mental hurdle to think about is at age 63, adding to your income could affect your health care costs. There are also, with the benefit of OB3, our latest tax legislation, a number of income-based thresholds for additional deductions, like deducting your car interest or that senior deduction or state and local taxes.

6:30So your income actually has a downstream effect in a lot of different ways. And so you want to consider all of those things when you're thinking about a Roth conversion. Yeah, there are many things that are affected by your adjuster gross income. The things you pointed out, premiums you pay for the ACA, your eligibility for certain student loan repayment programs, and of course, as you mentioned, all kinds of deductions and credits. So you really do have to look at the big picture, not just in terms of like, oh, if I convert$25 ,000 or even if I'm just contributing to a Roth, it's not just going to affect how much income is added.

7:05It will affect all these other aspects of your finances. That's right. That said, people love Roth accounts, right? And I understand it. there's sort of like a psychological appeal to it, right? You know that that money is completely yours. Uncle Sam's not going to have any access to it. But you think it's a mistake to overvalue the sort of tax-free aspect compared to what's really a mathematical reality. That is true. Having that tax prepaid can feel like a big psychological lift. You don't have to think about it again. But right now, and for most of history, we have had a progressive tax system, meaning you're not paying just one rate.

7:43You get a low rate the lower your income is, and then it graduates as you sort of go up the income scale. So what we see is that if you have everything in a tax-free bucket, you're actually giving up your ability to realize lower tax rates in the future. So on those first dollars that you're recognizing in taxable income, you're getting rates of 10%, of 12 % before you ever jump up to 22%. And let's not forget, because of the standard deduction, if you're married, you're getting$30 ,000 of tax-free income right off of the bat. So you don't want to give up those future free and low tax rate buckets in your exuberance to prepay that tax and recognize that benefit today.

8:34The point you're making there is, let's say you're in the 24 % tax bracket. That doesn't mean that every dollar of income you earn is taxed at 24%. Your income sort of moves up through the bracket. So a portion of your income will be taxed at a very low rate or basically be tax-free because of the standard deduction. Exactly. Yes. So it is a bit of a math problem, right? And I often recommend that people use some sort of online tool to analyze whether a Roth makes sense or not. But that said, you have found that some of these tools have limitations. What are some instances you've come across? Well, I find that these tools, whether it's an Excel spreadsheet or a more sophisticated program, do really well with linear assumptions that my income goes up 3 % every year and my spending goes up 2 % every year and I save X percent of my income.

9:25It does great with that. But the reality is that people have very fluid lives and fluid income situations. And so if you just take a single year and extrapolate it out to assume the same thing going forward, it yields subpar results because it doesn't actually line up with real life. The other thing that I see is a lot of people think that it's very conservative to assume a long life. Let's assume I live to 100 just to be really conservative and make sure I don't run out of money. Well, what's happening in the background of these tools is it saying, look how much you could save with a Roth because it's gonna keep compounding until you turn 100.

10:06And the reality there is you're actually not being conservative by assuming that long life expectancy in this case because it's overvaluing, it's weighing heavily that compounding that could occur over decades and decades of your life that statistically probably won't happen. We hope it will. We hope bionics and freezing organs and all that thing worked out for us. But realistically, most couples are not going to have 100 plus lifespan. And so these calculators are just giving extra credit, if you will, to those late compounding years, which are particularly weighty in the calculations. So some people are doing conversions or making contributions based on these tools.

10:51And sometimes it is just a mathematical answer, like, oh, the tool says I should do the conversions or make the contribution, so I just do it. They might be doing it for other reasons, right? One of the benefits of the Roth is there are no required minimum distributions. So you're seeing some people, especially retirees, they retire, their income drops, they do some conversions before those RMD years at 73, which can make sense in certain situations. But you've found circumstances when the conversion still may not make sense. So give us an example. Absolutely. I actually ran into this recently in talking to some prospective clients.

11:25We went through their situation and we determined that they really didn't have legacy goals in terms of passing their money to heirs or other human beneficiaries. They really wanted to focus on charitable beneficiaries. And so in that case, charities are not paying tax on any of the money that you give them. And so there's no need to prepay tax in that case. It would sort of just be a gift to the government at that rate to prepay tax on Roth conversions and then assign the Roth to a charity. So you really want to think about not just your use during your lifetime, but also what is the end goal if there is excess accumulated and making sure that you're being efficient about your choices there.

12:13So we're all familiar with diversification as a concept when it comes to our portfolios. You know, hell of a bit in cash, bonds, stocks, different types of stocks. But you believe that tax diversification is also important. And that can be done by having both traditional and Roth accounts. So tell us about tax diversification and why it's important. Yes. So diversification comes in so many flavors. And I particularly love the tax flavor. And when we think about that, I think in three broad strokes. One is that tax-free bucket like Roth IRAs, taxable like your regular brokerage account where you're just buying stocks with after-tax money and the appreciation gets that capital gains treatment all the way through to your traditional IRAs, 401ks, 403bs, things like that, where you're putting money in pre-tax and it's coming out to you totally taxable.

13:06And by having an accumulated funds in each of those tax buckets, you can really start building a retirement income stream that fits for each given year that you're experiencing. So it might make sense, for example, to accelerate ordinary income in years where you think you'll be in a lower tax bracket. Or you might want to focus on harvesting capital gains if you're able to stay in that 0 % capital gains rate. Or you might find maybe you sell an investment property and so your income is higher than usual. you might want to draw some funds from your Roth so that you're not increasing your AGI and triggering all of those downstream effects that we talked about earlier.

13:55So really having that optionality creates an opportunity to optimize in each year of your retirement or even leading up to retirement in how you create your own investment paycheck. Yeah, one example that I've given in the past is when my dad turned 80. He took us all on a cruise, which means he had to sell a ton of investments. He only had one type of account. So not only was it a big tax bill, but it caused his Medicare premiums to go up two years later. If he had had a Roth count, he could have instead tapped that and not had those types of consequences. Yes, or a combination of both. So let's close with some alternative strategies to consider.

14:34Yes. One of my favorite alternative strategies is the qualified charitable distributions. So a lot of times people think of Roth conversions as a way to reduce or eliminate their required minimum distributions in the future, which just as a mental note right now is for those age 73 and better are taking those required minimum distributions. But that's often conceived as like a mandatory tax, essentially. And that's what the government wants. They want their money to come to them. But what you can do with a qualified charitable distribution is actually tag a portion of your required minimum to go directly to charity.

15:16And that way it bypasses your tax return for the year. It's not recognized as income. It doesn't count as a deduction, but it does count towards meeting your minimum distribution for the year. So you've ticked your box on the requirement. You have controlled how much income is actually hitting your tax return, and you've achieved a charitable goal as well. And the nice thing about that is you can vary it every year. You don't have to sign up for a particular amount on an ongoing basis. You can just make an assessment on a year-by-year basis if you want to give zero or all of your required minimum to charity.

15:58So I love that strategy, particularly for folks who are making contributions to charity during their working careers to continue that in a different way as they transition to retirement. If you're interested in doing a QCD, make sure you look up the rules because you do have to do it correctly. So just throwing that out there. There is another account that we haven't touched on that is a health savings account. And it's often described as the best account to a certain degree because it is triple tax benefits. A deduction up front grows tax deferred and tax free if used for qualified expenses. What's your take on whether someone has to make a choice between an HSA and a Roth IRA or a Roth 401k?

16:38Obviously, it depends on a lot of situations, but should people be favoring the HSA? I think it's definitely a consideration, particularly for younger investors who have a long time for that HSA to compound before it is utilized. For older investors who are maybe closer to Medicare age, I think about the HSA being risky from an inheritance perspective because it's not a particularly nice inheritance asset, even though it's great for the primary user during your lifetime. And so the HSA is not something that's great to have in your sort of tax diversification buckets at death, whereas the Roth IRA is a great asset to have in your tax diversification buckets at death, particularly if you have named beneficiaries.

17:30So I think that can really make a difference in deciding which of these may be better. And it could be a situation where you sort of alternate in different tax years. This year, I'm going to do the HSA. Next year, I'll do the Roth. and that way you're getting a little bit of each.

18:17It's time to get it done, fools. And we're going to look forward a few weeks to 2026 and retirement account contribution limits, which are going up. The limit for IRAs will increase to 7 ,500. And the catch-up limit for those who will be 50 or older by December 31st of 2026 is increasing to$1 ,100. The limit for 401ks and similar types of employer plans are increasing to 24 ,500. workers who will be ages 50 to 59 or 64 and older on the last day of next year can contribute an additional catch-up amount of$8 ,000, while the catch-up limit for those who will be 60 to 63 is$11 ,250. Now, there's a new wrinkle that starts next year for those who will be 50 or older and earned more than$150 ,000 in compensation this year from their employer.

19:06The catch-up contribution must be deposited into a Roth account. If you've been contributing the entire amount to a pre-tax traditional account and don't change it, here's likely what will happen next year. The first$24 ,500 you save will go into that traditional account, but then the catch-up amount will automatically switch over to a Roth. So you'll be filling up the pre-tax bucket first. This has potentially two suboptimal consequences. Number one, your after-tax take-home pay may drop once contributions switch over to the Roth, which could be a bit of a shock for budgeting purposes if you weren't planning for it.

19:45And number two, money gets into the Roth account later. However, since the Roth is the tax-free account, you want it to be as big as possible, so you want the money to get in there as soon as possible, giving it more time to grow. The solution is to contribute to both the traditional pre-tax and the Roth account with each paycheck starting with the very first paycheck of 2026. The exact amounts will depend on how often you get paid and how much you plan to contribute, so check with your HR department or 401k provider to get some help with the calculations. Of course, this is only relevant if you want to contribute the most possible to the traditional account.

20:21If you were planning to contribute all your money to a Roth anyway, then this new rule really doesn't change anything for you. Also, the requirement doesn't apply to self-employed workers or people who change jobs. It only applies to people who are working for the same company in 2026 that they were in 2025. Finally, what if the company 401k doesn't offer a Roth option? Because not all do. Then in that case, catch-up contributions are not permitted for these higher paid employees. And that, my friends, is the show. Thanks for listening. And thanks, of course, to Bart Shannon, the engineer for this episode.

20:55As always, people on the program may have interest in the stocks they talk about. The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. I'm Robert Brokamp. Fool on, everybody.