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Are You Making Roth Contributions to Your Retirement Plan? Here's What You Need to Know!

J. Timothy Corle, CPC, CFP®

President, CEO


When I first started out in the retirement plan business, pre-tax contributions were all that were allowed, and they were easy to understand.  The idea was simple -- save for retirement by deferring your taxes to a later date, minimizing the impact on your take-home pay each pay period. The assumption always was that your tax bracket while you are fully employed will always be higher than your tax bracket in retirement, because your annual income will decrease as a result of not being fully employed anymore.

This made perfect sense to me, and I spent years coaching people on how it works and why they should save this way.  It was good advice….and it was the only advice, because there was no alternative if you wanted some kind of tax benefit to saving for retirement.

To be honest, when the Roth IRA was first created in 1997, I didn’t see what the big deal was.  I wondered, why would anyone want to pay taxes now?  In 2006, when they came to 401(k) plans, I was still wondering why give up the current day tax benefit?  After all a bird in the hand is worth two in the bush, right?

Bear in mind, I was thinking this because I understood this basic mathematical principal that many did not:  If tax rates are the same when you withdraw the money as the day you saved the money, it didn’t matter which way you saved it, the amount you have to spend is exactly the same.

Let me show you what I mean:

Let’s say you have an annual budget of $5,000 to save for retirement, how does that break down between the two methods?



Roth contributions are always a better deal in the long run when you know that your tax rate today is likely lower than when you withdrawal the money in retirement, but how can you really know for sure?

It is said by many that Roth favors the young, and this is certainly true for the most part. When you are first starting out in an entry-level position, your earnings are much lower than they will be 10, 20, 30 years from now.  Lower earnings equal a lower current tax rate, so every dollar you save when you are young and in a low tax bracket is an inevitable win. This is based on the reasonable assumption you will be in a higher tax bracket later.

But what about everyone who is well established at this point, and may have already reached their peak income tax bracket?  Well, today I believe you have an opportunity that doesn’t come around very often.

On January 1, 2018, federal income tax rates did something they don’t do very often….they dropped!  They didn’t drop forever, only until January 1, 2026 when they go back up to pre-2018 levels.  The only thing that has to happen for tax rates to go back up is for Congress to do absolutely nothing on the subject. I won’t talk politics, other than to say, the idea of Congress doing nothing doesn’t sound so far fetched to me.

This gives everyone who is in the workforce for the next seven years a rare opportunity to pay a lower tax rate now on retirement contributions, and never have the money taxed again at what are likely to be higher rates down the road.

Good financial planning for retirement involves three “buckets” of money:

  1. Taxable Bucket – This is your current savings and investments that are not in a retirement plan. Money markets, CD’s, mutual funds, etc. that are a result of your personal savings.  You pay the taxes on the income and capital gains on the money in this bucket each year as you receive the income.
  2. Tax Deferred Bucket – This is your pre-tax 401(k), employer profit sharing/pensions, traditional IRA accounts. You did not pay federal income tax on this money when it was put in the account, you deferred the tax until you withdrawal it at a later date.
  3. Tax Free Bucket – This is any Roth money you have saved, cash value life insurance, an HSA, municipal bonds, etc. When this money is withdrawn, if done according to the rules, will not increase your income for tax purposes, and will not be subject to any taxes…you already paid them years ago when you saved the money.

Having money in all three buckets gives you some choices in retirement as to where you take the money you need to meet your living expenses.  In other words, it is a way to diversify your tax burden.  In retirement, if you have money built up in all three buckets, you have the flexibility to decide which combination of buckets you withdraw from based on the tax rates at the time.  Doesn’t this make sense?  We diversify our investment holdings between stocks, bonds, real estate, etc. so we can reduce volatility and increase our investment flexibility and growth potential as we accumulate the money... why shouldn’t we also diversify our tax picture by not putting all of our money in one bucket?

Here is an example:

If you withdraw $75,000 from your tax deferred 401(k) plan, you would pay ordinary income taxes of $16,500 (assuming you file individually and are in the 22% tax bracket); this would net $58,500.

However, if you have money built up in all of the buckets I described above, you have more flexibility.  Let’s assume you withdraw $25,000 from each bucket to make up your $75,000 withdrawal:

 

  • Taxable Bucket – $25,000 withdrawal, and let’s assume it is all a capital gain, you would pay a capital gains tax of 15%, or $3,750, leaving you with a net of $21,250.
  • Tax-Deferred Bucket - $25,000 withdrawal, all taxed as ordinary income at a 22% rate, the taxes would be $5,500, and you would net $19,500.
  • Tax-Free Bucket - $25,000 withdrawal with no tax liability would net you $25,000.

 

So for the same gross withdrawal of $75,000, you actually net $65,750, a difference of $7,250!  All because you diversified your tax picture in advance.

With tax rates historically low, I would argue that it makes a whole lot of sense for everyone to start filling that tax-free bucket.  The easiest way to start doing that is by changing your 401(k) contributions to Roth instead of pre-tax.

At Tycor, we help people with this -- and many other financial and retirement planning situations. If you have questions on the content of this article, or any financial planning question, please give your friends at Tycor a call at 610-251-0670.