I’ve found many employees go for the tax deduction 100% of the time. A bird in hand is worth two in the bush, as the old saying goes. Yes, going with the traditional option results in more money in your pocket now, but I argue that ignoring the potential value of Roth contributions is a bit short-sighted.
Remember, with traditional contributions you get a tax deduction in the year you make the contribution. Your contribution is not added to the rest of your income for the tax year and taxed at ordinary income tax rates. This results in more net income in the year of the contribution when comparing traditional vs Roth contributions because of the tax deduction. Earnings accrue tax deferred, along with your contribution, until you decide to withdraw it penalty-free come age 59 1/2 or older.
It’s then time to satisfy Uncle Sam’s greed for your tax money. Any withdrawal of principal and/or earnings are added to the rest of your ordinary income for the tax year (if any) and taxed at ordinary income tax rates.
With Roth contributions, they’re taxed in the year you make the contribution. That contribution is added to the rest of your ordinary income for the year and taxed at ordinary income tax rates. This results in less net income for the year when comparing traditional vs Roth contributions. In turn, your earnings (interest, dividends, and capital gains) accrue tax-free. Since you already paid tax on the principal in the year of your contribution, this results in a 100% tax and penalty-free withdrawal come age 59 1/2.
When arguing with seminar attendees regarding traditional vs Roth contributions, I often get the following argument: I’m going with all traditional contributions. I’m in a higher tax bracket now. Making a Roth contribution will cost me big money in extra taxes. Better to defer that tax liability until retirement. My ordinary income tax rates will of course be much lower then because I won’t be working.
They’re assuming ordinary income tax rates remain at current levels and may have forgotten that ordinary income tax rates are changed frequently by Congress. This is true at the federal, state and local levels. With Covid, climate change, and all the rest of the problems facing us, do you really think ordinary income tax rates will remain at their current historically low levels? I’m very skeptical.
Build Your Wealth With Both
That’s why I recommend building both traditional (pre-tax) and Roth investments into your retirement accounts. I’ve never met a retiree who regretted having too much tax-free cash. Plus, the last thing you need in the latter part of your retirement is a tax problem thanks to RMDs.
Each year, figure which type(s) of contributions you should make: All Roth contributions, all traditional contributions, or a combination of the two. Consider your projected taxable income for the present year, for future years, as well as your income needs for the current year.
Let’s say you’re twenty-one and just getting started in the workplace. You’ll want to make all Roth contributions.
Unless you’re a professional athlete or Hollywood movie star, you’re probably in a lower tax bracket at this point. It just makes sense to get that tax liability over with while it’s so low. Plus, your time horizon for investment is extremely long (around 45 years), so lots of earning can be expected, making the choice a no brainer.
Instead, let’s say you’re in your 60’s, at the top of your pay scale at work, have two kids in college, and plan on retiring soon. You’ll probably want to make all traditional contributions.
That tax deduction is more valuable than ever now that you’re in a higher tax bracket. Making a Roth contribution at this point costs you big bucks, which you need to pay for your kids’ tuition. Finally, because you’re retiring soon, earnings will be limited, thus reducing the utility of tax-free earnings.
Traditional vs Roth
Traditional vs Roth contributions? Embrace both kinds of contributions. Some years it will be clear cut which type of contributions to make, while in others it will be more muddled. Managing these year-in and year-out decisions regarding traditional vs Roth contributions effectively is one more way you can amplify your after-tax bottom line.