If you’re caught in a no-man’s land somewhere between Roth and traditional contributions trying to figure out whether to pay taxes now or later, you’re not alone.
The Roth versus traditional discussion is happening on talk shows and in news columns, magazine articles, blogs, and message boards.
Gathering information and engaging in your retirement planning is a healthy and helpful exercise, but don’t listen to the one-size-fits-all pundits. Roth isn’t categorically better, and neither is the traditional option. Everything depends on your personal situation. And sometimes a combined approach may work out best.
The ups and downs of a traditional contribution
Traditional 401(k) contributions come out of your paycheck before you pay taxes. As a result, traditional contributions lower your taxable income. The immediate, concrete benefit is that you’ll cut Uncle Sam a smaller check in April.
On the flip side, you’ll have to pay ordinary income taxes on traditional 401(k) distributions during retirement. The $50,000 per year you thought you’d have during retirement could be much lower depending on your tax bracket.
The ups and downs of a Roth contribution
Roth contributions come out of your paycheck after you pay taxes. You’ll see the major benefit during retirement: no ordinary income taxes on Roth contributions or any resulting capital gains.
You don’t get to reduce your current taxable income, but you get to keep 100 percent of each Roth distribution during retirement. Roth contributions are simpler and leave fewer future unknowns.
Who benefits from what?
For a few people, the benefits of one contribution method seem obvious.
For example, a recent college graduate making relatively little money is currently in a low tax bracket. She doesn’t stand to benefit significantly from lowering her taxable income because she’s already in a low tax bracket. Though the future isn’t certain, we can make an educated guess that she’ll be in a higher tax bracket during retirement than she is now. Paying income taxes now seems to be a better idea than paying later when she’ll pay at a higher rate.
Conversely, a 65-year-old executive who’s at the peak of her earning years is currently in a high tax bracket. Reducing her taxable income could be very beneficial, and it doesn’t seem that her tax rate will be higher during retirement than it is now. Making pre-tax traditional contributions now seems to be a better idea.
The big question: What does the future hold? Without a crystal ball, it’s impossible to know what your tax rate will be during retirement, even if you know what your income will be. When the tax code changes, each set of Roth and traditional advantages could also change.
To mitigate the risks associated with an ever-changing tax code, you can engage in tax diversification. In the larger investing world, there are many ways to implement tax diversification. Talk to your tax professional about your options. In the 401(k) realm, your major option is to divide your contributions between Roth and traditional, taking into consideration any contributions your employer is making on your behalf.
As with asset class diversification, there are details of your personal situation that can assist you in determining your Roth/traditional split. The aforementioned “Who benefits from what?” examples are still applicable, but each investor could diversify with smaller contributions in the seemingly less-advantageous form.
It’s also noteworthy that individuals who are closer to retirement have more tax certainty than people with a longer retirement timeline. These near-retirees can make more contributions with planning based on the current tax code.
Since most earners are neither 22 nor 65, most of us face a significant gray area in deciding what our Roth/traditional split should be. As you decide, talk to your retirement adviser and tax professional about the particulars of your situation. And, as with your asset class allocation, make decisions that allow you to rest comfortably at night.
Scott Holsopple is the president and CEO of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal. Keep tabs on Scott on Twitter and Facebook.
Nothing in this article should be construed as tax advice. Contact a qualified tax professional to discuss the tax implications involved in the decision to make Roth or traditional contributions to your retirement plan as well as any other tax matters relating to your retirement plan options.