Ask a Planner – Dana R. Cahan, CPWA, Wealth Advisor
“I contribute to a 403(b) pre-tax retirement account and my employer has offered a Roth contribution as an option for our retirement plan. I am 66 with plans to retire in Jan ’25. How do I decide if I change my contributions to pre-tax to Roth?”
Thank you for the submission. This is a great question and one that more people are going to be facing in the next few years thanks to the recent passage of Secure Act 2.0, which includes a number of provisions made to encourage more companies to offer Roth options. There are multiple factors to consider when deciding whether to contribute to a pre-tax or Roth 401(k) or 403(b) in an employer-sponsored retirement plan—most commonly discussed is the difference in tax treatment though it is critical to also consider age, projected-life span, spending/lifestyle objectives, composition of other existing accounts (taxable and non-taxable accounts), as well as your legacy objectives. I’ve outlined some of these considerations below in an attempt to assist you in making the most educated decision that meets your financial situation.
The basic difference between a traditional and a Roth 401(k) is when you pay the taxes. With a traditional 401(k), you make pre-tax contributions, so you get a tax break up front, helping to lower your current income tax bill. Both your contributions and earnings grow tax-deferred until you withdraw the money. At that time, withdrawals are considered ordinary income and you will have to pay tax at your current tax rate.
A very important and often overlooked factor here is the potential impact of Required Minimum Distributions (RMDs) which can be significant. All traditional IRAs and 401Ks are subject to RMDs once the participant reaches a required age. RMDs begin at about 4% and increase annually. These distributions are fully taxable and, when combined with other sources of income, can trigger additional taxes.
With a Roth 401(k), it’s basically the reverse. You pay tax on your contributions now, at your current tax rate, meaning there is no upfront tax deduction. However, withdrawals of both contributions and earnings are tax-free at age 59½, as long as you’ve held the account for five years. There are also no RMD requirements on Roth accounts during one’s lifetime* so money in a Roth account continues compounding and growing tax-free until you decide to withdraw from the account, enabling individuals to maintain a potentially lower taxable income in future years.
Thus, a big factor to consider is your current income and tax bracket and what you expect your income and tax bracket to be in retirement. This is why, generally a Roth 401(k) is more advantageous for people in their 20s or 30s who are in a lower tax bracket who have a long time before retirement because the tax deferred accumulation and growth will likely surpass the accumulation of the amount paid in tax at the onset. However, this is not always the case and the calculation becomes more complicated for older adults nearing retirement.
It is also important to note that we do not know where tax rates will be in the future. For example, in 2023, a married couple with a taxable income of $364,200 can remain within the 24% tax bracket. However, in the absence of congressional intervention, the Tax Cuts and Jobs Act will sunset at the end of 2025, resulting in a reversion to the 2017 tax rates and brackets. Under this scenario, a married couple’s taxable income over $153,100 (not adjusted for inflation) will be subjected to a 28% tax.
Also, if you are focused on generational wealth and transferring assets to the next generation then it would be advisable to consider using Roth accounts for estate planning purposes, considering that inherited Roth accounts are more beneficial for heirs and legacy planning. Even though an inherited Roth account will still have to be distributed over ten years, provided that the Roth account is at least five years old, the beneficiary would not have to pay income taxes on the distributions from the account making the inherited benefit even greater.
In 2023, employees can contribute up to $22,500 (or $30,000 if 50 or older) into employer sponsored plans. It is often very beneficial to have both pre-tax and Roth dollars to rely on during retirement, so If the employer offers both traditional and Roth options, a compelling option would be to split your contributions between the two types of accounts. Determining how much to allocate between the two options also depends on the composition of one’s overall estate plan and asset allocation including other existing accounts (IRAs or Roth IRAs, as well as other taxable accounts). Ultimately, this is a complicated and highly personal decision that depends on an individual’s specific circumstances and timeline. Reach out if you have any questions or want to discuss how to think through making this decision personally.
Reach out if you have any questions or want to discuss how to think through making this decision personally: dc@zuckermaninvestmentgroup.com.
Written by Dana R. Cahan, CPWA