By Dr. Leif Dahleen of Physician on Fire, WCI Network Partner
When investing in retirement accounts such as a 401(k)—or perhaps, for you, it’s a 403(b), SEP or SIMPLE IRA, or another variety—you will likely be faced with a choice. Do you invest in a traditional, tax-deferred manner or make Roth contributions? Maybe both?
Whatever you choose, it’s important that you invest. If you’re employed, there’s a good chance you’ll have some matching dollars invested on your behalf. Even without a match, there are wonderful tax advantages to either option, so be sure to invest as much in these accounts as you possibly can.
Before we discuss the factors that should push you in one direction or another, let’s review the two options.
- Traditional contributions to retirement accounts are tax-deferred. That means every dollar contributed defers a dollar’s worth of tax from now to a future date. You won’t pay tax on that dollar in the tax year in which you contribute, but you will eventually pay income tax when you withdraw the money from the account. A high-income professional who invests $20,500 in a traditional 401(k) can expect to save $7,000-$10,000 on income taxes in 2022 (assuming a total federal, state, and local marginal tax rate of 34%-49%).
- Roth contributions to retirement accounts offer no such benefit on the front end. That same high-income professional making 100% Roth contributions to their 401(k) or 403(b) will pay $7,000-$10,000 more in income taxes in 2022 compared to the person making traditional contributions. The biggest benefit of the Roth contribution comes on the back end. No taxes will be due when the money is withdrawn. Another benefit, particularly for those with large estates, is that Required Minimum Distributions (RMDs) are not mandated for Roth IRA accounts, although the same is not true for a Roth 401(k) or 403(b), both of which could be rolled over to a Roth IRA once you've left your employer.
Both types of contributions will benefit from tax-free growth. Unlike money in a taxable brokerage account, no taxes are levied annually on dividends and capital gains within a retirement account like the ones we’re talking about today.
Pay Taxes Now or Pay Taxes Later?
Or pay taxes never? More on that third option later.
Most likely, you’ll be paying taxes on your earnings at some point. The biggest determinant of when you should pay that tax is whether you expect your marginal tax rate to be higher or lower in retirement than it is right now. There is some guesswork involved here, but there are a number of indicators that can help you make an educated guess.
If you expect to be in a lower tax bracket when you’re no longer earning an income and withdrawing from your retirement account, you should choose traditional contributions today.
If you expect to be in a higher tax bracket as a retiree than you are right now, Roth contributions are the obvious choice.
If you anticipate no change in your marginal tax bracket, you’ve got a choice to make. I’d lean toward Roth contributions, as you’re effectively investing more of your own money in a tax-protected account. When you invest in a tax-deferred manner, a portion of that $20,500 belongs to the government. This could also be a good place to hedge your bet and make both traditional and Roth contributions.
More information here:
Factors Favoring Traditional Contributions
The more boxes you can check in the following list, the more traditional, tax-deferred contributions make sense for you. Factors that favor traditional (tax-deferred) contributions:
- High Income
- High Tax Bracket
- Single (higher tax brackets for single filers)
- High Income Tax State
- You Also Invest in a Taxable Account
- Close to Retirement
- Likely to Retire Early
- Anticipating Lower Taxable Income in Retirement
- You’re in a “Phase Out” Income Range for a Tax Deduction or Credit
- You’re a Natural-Born Saver
Let’s dig deeper into these one at a time.
If you are earning a great income now, you can use all the help you can get, given the progressive nature of our federal income tax. If you’re in your peak earning years, tax-deferral can save you money now.
Along those lines, having a high marginal tax bracket favors traditional contributions. While this is a borderline redundant bullet point, high income is subjective, whereas marginal tax brackets have no gray areas. For example, you may be in academic family medicine earning under $200,000. That may be on the low end of the doctor pay scale, but without some tax deductions, as a single person filing an individual tax return, you’ll find yourself in the 32% marginal tax bracket.
If the state you currently live and work in has a high state income tax, particularly one with a progressive state income tax, the tax deferral becomes even sweeter. If there’s a chance you’ll someday move to a low or no state income tax state, that tips the scales even further in favor of traditional contributions.
If you’ve got a good amount of money in a taxable brokerage account, you’ve got some tax diversification in your portfolio already. Those post-tax dollars have already been subject to the bulk of the taxes they’re going to see. That money gives you some flexibility in tax planning as a retiree. Taxable dollars are the next best thing to Roth dollars.
If you’re close to retirement, you’re better able to model what your future taxable income and tax situation will be. I consider this a reason to make tax-deferred contributions.
If you’re retiring within the next few years, you’ll likely be subject to the current tax rates which recently became more favorable. At least in the early years after you retire, tax brackets should not be drastically different than they are today, although the winds of political change can make a difference in a hurry.
If you plan to retire long before you turn 72 and required minimum distributions are mandatory, you’ll have plenty of time to convert traditional dollars to Roth, quite possibly in a lower tax bracket than you are today.
Related to future modeling, if you’re close to retirement, you’ll have a good idea of what your income streams are going to be and how that money will be taxed. If you’ve got a sizable taxable brokerage account and/or Roth account(s), you can probably expect to have a lower taxable income to meet your spending needs in retirement, as many of your dollars are already post-tax.
If you have a household taxable income that subjects you to a phase-out or elimination of a tax deduction or credit, the tax deferral can be particularly advantageous. This might come into play for a physician working on a 1099 basis (independent contractor) who is gradually phased out of the 20% pass-thru deduction with a household taxable income from $340,100-$440,100 if married filing jointly (half those numbers for single filers) in 2022.
Finally, traditional contributions are better for natural-born savers. Why? With tax-deferred contributions, you’re going to pay less tax, which means you’ll have more of your “disposable income” at your disposal. If you are likely to save and invest the tax savings, traditional contributions give you more money to invest.
More information here:
Factors Favoring Roth Contributions
If you’ve read all I’ve written thus far, take the exact opposite of the preceding paragraphs and you’ll come up with reasons that Roth contributions are wiser. I’ll list them for you and give a brief overview of the rationale, but it should be fairly intuitive. Factors that favor Roth contributions:
- Lower Tax Brackets
- Married Filing Jointly (related again to tax brackets)
- Low or No Income Tax State
- Few Investments That Are Not Tax-Deferred
- Far from Retirement
- Planning on a Traditional Retirement Age
- Anticipating Equal or Higher Taxable Income in Retirement
- You’re a Natural-Born Spender
If you’re not in your peak earning years; if you're not in that 32% or higher federal income tax bracket; and if you're not having much, if any, state income tax burden, Roth contributions may be just the thing for you.
If you don’t pay state income tax (or much of one), the tax deferral from traditional contributions won’t benefit you as much. This is especially true if you’re planning on retiring in a place with higher state and/or city income taxes.
There is some benefit in tax diversification among your investment accounts. If all you’ve got to date is tax-deferred dollars saved up for retirement, you have very little flexibility in how you access your money. You’re essentially at the mercy of your annual spending.
Having some Roth contributions will allow you to spend down your retirement assets in a more flexible and potentially tax-efficient manner.
If retirement is a long way off, retirement is more like a box of chocolates; you never know what you’re going to get. It might be marginal tax rates exceeding 50%. It might not be, but the future is unknowable. You may be more comfortable paying taxes at today’s known rates than crossing your fingers in hopes of taxes not going up in the next 20-30 years.
Retiring at 65 or 67 doesn’t leave much time for Roth conversions before RMDs kick in on tax-deferred dollars. You may be better off putting money into Roth now.
While I don’t expect many of us wage-earners to be in higher tax brackets in retirement, it is possible for the ultra-high net worth types and those who end up with eight-figure tax-deferred retirement accounts. If that’s you or is going to be you, consider making some Roth contributions now. You’re going to have more money than you need either way.
Last but not least, if you’re a natural-born spender, lock that money up in Roth contributions. It’s a form of forced savings. You won’t have that extra $7,000-$9,500 to blow on an 85-inch outdoor 4k television.
Paying Tax Never
While it’s less likely that a high-income professional will find themselves in this position, it’s worth mentioning that tax-deferred contributions can become tax-free on withdrawal with a low enough taxable income. Roth conversions can also be done in the tax-free zone.
The standard deduction is now $25,900 per couple in 2022. That means you can have $25,900 in taxable income without paying a penny in tax.
Let’s say you’re living on a modest budget of $50,000 a year as empty-nesters with a paid-off home; $39,000 comes from a $500,000 taxable account invested in growth funds and no-dividend stocks like Berkshire Hathaway. Selling the most recently purchased shares, you only take $8,000 in long-term capital gains, and the $500,000 account spits off another $5,000 in dividends.
You’re now at $13,000 in “taxable income,” although dividends and capital gains are untaxed up to a taxable income of $83,350 in 2022. That gives you $12,900 to play with before any federal income tax would kick in. That means $11,800 could be withdrawn from an IRA to make up the rest of the annual budget.
If you’ve got children under 17 at home, you can take a much larger withdrawal (or make Roth conversions) without owing tax since you now get a $3,000 tax credit per child.
Far-fetched? Maybe. But certainly not unheard of. See The Taxman Leaveth for details on six-figure spending budgets with no federal income tax.
More information here:
The Likelihood of Lower Taxes in Retirement
While few of us will find ourselves in the situation described, there is lots of room in the lower tax brackets to withdraw tax-deferred money, offering an opportunity to later take advantage of the tax arbitrage offered by deferring $20,500 a year at your current marginal tax bracket.
Some people balk at the idea of being in a lower tax bracket in retirement, as it suggests to them a lower standard of living. For the high-income professional, this is utter nonsense.
Let’s say you’re like Dr. C. Raising a family, paying the mortgage, and living well, you’re spending $160,000 in your working years. You earn $300,000 as a household, and after taxes, you’re setting aside about $80,000 per year for retirement.
Once you’re retired, the mortgage is paid off, and you’ve put the kids through college. Now, you can live the same lifestyle on $120,000 a year. Let’s say $10,000 comes from qualified dividends in a taxable account; $50,000 comes from selling shares from that taxable account, generating $25,000 in long-term capital gains; and $60,000 comes from a traditional 401(k) (or traditional IRA, etc.).
Your taxable income is the $10,000 in dividends, the $25,000 in capital gains, and the $60,000 from the tax-deferred account for a total of $95,000. You’re still married after all these years and take the $25,900 standard deduction, reducing your taxable income to $69,100.
That puts you in the 0% bracket for the dividends and capital gains, so you only owe tax on the $60,000 you withdrew from the 401(k) or IRA. You’re in the 12% marginal tax bracket and owe about $4,000 in federal income tax on a $120,000 annual budget.
What I Did with My 401(k) Contributions
As you might have guessed, I take advantage of every penny of tax deferral I’m allowed. That means traditional, tax-deferred contributions to my 401(k) and 457(b) and my HSA (which is the only option here).
When working, I checked nearly all the boxes in the list of factors that made tax deferral a better choice. I had a high income. We were living in Minnesota. We have a progressive state income tax with a top bracket (which we were in) of 9.85%.
More than half of our assets are currently in taxable investments. That includes our Vanguard brokerage account, passive real estate investments, our second home, and additional lakefront property.
We already have more Roth money than tax-deferred money. I made a “mega Roth conversion” of over $300,000 from a SEP IRA in 2010, and we make annual Backdoor Roth contributions.
I will almost certainly be in a lower income tax bracket when I stop earning an income. Tax-deferred investments account for 17% of our retirement assets. It would not be at all difficult to have many zero-federal-income-tax years if I were to retire completely today.
Last, but not least, I’m a natural-born saver. Money has burned no holes in my pockets.
What has been your approach to retirement contributions? Do you make mostly traditional or Roth contributions? Will that change for you in the future? Comment below!