One of the most common questions we are asked as fee-only financial planners is “Should I make pre-tax or Roth contributions to my 401(k) plan?”
It is a choice faced by almost everyone. Whether you are a doctor in Minneapolis, a software engineer with stock options in Portland, or a banker in Charlotte, it is the first place most of us look to start building tax-advantaged investments.
So, what should you do?
There are a few variables that should guide your decision. Surprisingly, the impact of Coronavirus on our economy may be an important one. But before we get there, let’s start at the beginning.
First Things First
Before diving into the tax aspects of your decision, there is a more important question you need to be asking yourself: Am I saving enough? Reducing your tax bill is great, but none of that matters if you are not saving enough in the first place. That’s why the first answer to our question is simple: the right path is whichever one lights a fire in you to start saving more. The latest academic research in financial planning indicates that most of us will need to have a savings rate of at least 16% over the course of our lifetimes to confidently retire. I’ve had many clients that need the incentive of saving tax dollars today in order to start increasing their 401(k) contributions. If you fall into that category, that’s completely fine (I have myself at times). Make pre-tax contributions and increase your contribution percentage. Be sure to contribute at least enough to receive your full employer match.
Summary of Key Points to Guide Your Decision
- Compare your tax rate today to your expected tax rate in retirement.
- Consider the risks of higher tax rates in the future due to today’s large government deficits.
- Aim to build tax diversity within your investment portfolio, including a healthy balance of all three tax buckets: taxable, pre-tax and Roth.
- The dramatic increase in federal and state budgets due to Coronavirus make it more likely that tax rates will increase in the future.
Taxes Today versus Taxes in the Future
Time to start diving into the tax consequences of your decision. If we could boil down the answer to our question to one key, driving variable, it is this:
Compare your tax rate today to your tax rate in the future. If your tax rate is higher today than it will be when you take distributions from your retirement plan (likely in retirement), you should make pre-tax contributions. Conversely, if your tax rate is lower today than it will be when you take distributions, you should make Roth contributions.
The logic behind this is straightforward. With pre-tax contributions, you receive a tax deduction today but pay tax when you take distributions from your account. Therefore, if your tax rate is higher now than in the future, pre-tax contributions would be better than Roth. This is because it would be more advantageous to receive a tax deduction at today’s higher tax rate, then pay tax on your distribution at your future lower tax rate.
Conversely, if you are in a lower tax bracket than you expect to be in the future, it would be more advantageous to pay tax on your wages now to avoid creating taxable income at the time of future distributions, when you expect to be in a higher bracket. This would imply Roth contributions are the best route for you.
The prevailing wisdom is that pre-tax contributions are more advantageous during your peak earning years because your income will naturally be higher at this point of your life than in retirement. The picture below illustrates the income trajectory of a typical household. A lot of “rules of thumb” are based on this common pathway. Assuming your situation falls into this standard mold, pre-tax contributions very well could be the best route. However, there are many cases that could lead to a lower tax rate today than in retirement:
- If you are a big saver or expect to inherit money down the road, your required minimum distributions could be fairly large in retirement. This could lead to a higher tax rate after age 72 (when required minimum distributions need to begin), especially if your portfolio performs well.
- If most of your retirement portfolio is already pre-tax, this could lead to unusually large required minimum distributions relative to your net worth and living expenses, which could tip you into a higher tax bracket after age 72.
- If you have strong pension benefits in addition to a healthy amount of pre-tax savings, it could lead to higher taxable income in retirement than during your working years.
- If you plan on retiring in a higher tax state, such as California, your state tax rate could be lower right now depending on where you live and work.
- If you plan on taking extended time off from work, it could lead to a temporary dip in income. Switching your contributions (or your partners contributions) to Roth before you leave your job may allow you to take advantage of your temporarily lower tax rate.
- You may be at a point in your career where you know your income is much lower than it will be in the future, such as a doctor in residency. If your earnings power is set to dramatically increase, it’s highly likely that you will be able to build significant assets for retirement, which could lead to a large amount of retirement income.
These are only a handful of examples that could lead to a lower tax rate during your career. If these scenarios apply to you, Roth contributions very well could be advantageous. But more importantly, there is one critical variable that our “typical lifetime income trajectory” model overlooks: tax rates themselves might change.
A Historical Perspective
The pre-tax versus Roth decision is rarely straightforward because we have little clarity on one of the most important variables in your decision: future tax rates. While we can’t predict the future, there are two factors that can help us understand what might happen to future tax rates:
- Comparison to historical tax rates. We all feel like we pay too much in taxes. But it may surprise you to know that our current tax rates are fairly low compared to their historical levels. Today’s current top marginal tax bracket for federal taxes is 37%. Comparatively, it ranged between 50% and 92% from 1932 (after tax rates jumped following the New Deal) to 1987 (when they were lowered by the Tax Reform Act of 1986). On a historical basis, today’s 24% federal tax bracket, which goes up to $326,600 of income for married couples, looks particularly attractive. On top of this, taxpayers in the $200k to $300k income range rarely pay alternative minimum tax, which was much more common before the Tax Cuts and Jobs Act passed in 2017.
- Look at the health of our government’s current finances. While looking at historical tax rates is instructive, it is really the state of our current government finances that will drive future tax policy. Unfortunately, it does not look pretty right now. Before Coronavirus battered our economy, we were already running large budget deficits. After adjusting for the expected impact of Coronavirus, our government is projected to run a deficit equal to 19% of our GDP. This will easily be the largest deficit since World War II, nearly doubling the size of the deficit during the 2008-2009 financial crisis. While a return to economic health would certainly improve future deficits, a deeper and more prolonged the economic downturn would mean our current spending level is less and less sustainable. In that scenario, there would only be two ways to solve our problem: cut spending or raise taxes.
So, what does this mean for your pre-tax versus Roth decision? It means that Roth contributions are looking increasingly attractive compared to pre-tax contributions, all other things being equal.
The Importance of Tax Diversification
Our discussion on the impact of future tax rates leads us to an important topic in tax planning: making decisions in the midst of uncertainty. Uncertainty looms everywhere in our process. For example:
- We don’t know how much income you will earn in the future.
- We don’t know exactly when you will retire.
- We don’t know how your investment portfolio will perform (which impacts your retirement income).
- If you are going to inherit money, we don’t know exactly how much.
- We don’t know if social security benefits will be reduced in the future (which could impact your retirement income).
- We don’t know what tax rates will be in the future.
Yet, despite all this uncertainty, we still have to make tax planning decisions, such as your pre-tax versus Roth 401(k) decision. This is why I’m a big proponent of building tax diversity in your portfolio. What does “tax diversity” mean? It means building a healthy mix of pre-tax, Roth and taxable assets in your portfolio, and avoiding becoming too concentrated in one of those three buckets. At its core, it’s no different than ensuring your portfolio is diversified between asset classes, such as international and US stocks.
Why is “tax diversity” important? There are two key reasons:
- It reduces risk. If your portfolio becomes too concentrated in one of the three tax buckets, you become more exposed to certain changes in future tax policy. For example, if your entire portfolio is in the pre-tax bucket (which is more common than you might think), your retirement could be negatively impacted to a dramatic degree if tax rates increase in the future.
- It provides flexibility for you to capture tax planning opportunities throughout your life. At various times throughout your life, it will be advantageous to either accelerate or defer income. For example, many retirees have a window of time between their retirement date and claiming social security where their taxable income is very low. In such cases, it can be highly advantageous to complete Roth conversions, accelerating taxable within the lower tax brackets. To pull this strategy off, though, you need sufficient taxable assets to cover your living expenses. If you don’t have enough in the taxable bucket, you would lose out on a highly valuable planning strategy.
Take a look at your personal balance sheet today. How diversified is it from a tax standpoint? If it is heavily concentrated in one of the three tax buckets, you may want to focus on building up the other two. This should guide your pre-tax versus Roth 401(k) decision.
An Overlooked Benefit to Roth Contributions
There’s one other benefit to Roth contributions that few realize: you are able to contribute more to your 401(k) on an after-tax basis when making Roth contributions than pre-tax contributions. The math is simple: if you contribute $19,500 to your 401(k) on a pre-tax basis and have a tax rate of 32%, this is the equivalent of $13,260 on an after-tax basis. Conversely, if you contribute $19,500 to your 401(k) on a Roth basis, the entire contribution is already “after-tax”.
Coordinating with Other Tax Planning Strategies
The last component to your pre-tax versus Roth is perhaps the most important: you will need to ensure it is coordinated with any other tax planning strategies you are implementing. Here are some examples:
- 2020 Economic Impact Payments – If your income was too high to receive an economic stimulus check this spring, you may still be able to receive it when filing your 2020 tax return if your income is lower this year. Making pre-tax contributions this year will help reduce your income, increasing the likelihood that you would fall under the income thresholds to qualify.
- Student Loan Planning – Many student loan planning decisions are driven by your income level. For example, the student loan interest deduction phases out as your income increases. By making pre-tax contributions, you would lower your income and increase your likelihood of being able to claim the deduction.
- Qualified Business Income Deduction Planning – Taxpayers that receive passthrough income, such as sole proprietors, partners in a partnership, or S-Corp owners, may qualify for a special 20% deduction against such income. However, if your business is deemed to be a “specialized service trade or business” (SSTB), your deduction becomes limited (and eventually phases out) once your income exceeds $163,300 for individuals and $326,600 for married couples. Making pre-tax contributions would help you stay under these thresholds, thereby maximizing your QBI deduction.
- Charitable Planning – If you make significant charitable contributions in a single year, it could temporarily drop you into a lower tax bracket, thereby making Roth contributions more attractive.
On the surface, your pre-tax versus Roth decision seems fairly straightforward. However, once you start to peel back the layers of complexity involved, you can see that it is anything but a simple decision. If you have a clear sense of how your tax rate today compares to your future tax rate, make your decision accordingly. If not, today’s historically low tax rates and our government’s ballooning budget deficits mean that Roth contributions are looking increasingly attractive.
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