Traditional vs. Roth Deferrals in Retirement Plans

What to Consider

Many investors have heard of Roth IRAs and the significant advantages they can provide. In fact, these investment vehicles are so powerful that the government has set income limitations restricting who can contribute to them. In the past, investors with high-income levels that wanted to use Roth IRAs were basically left high and dry — until just recently.

Beginning in January 2006, employer-sponsored 401(k) and 403(b) retirement plans started offering after-tax Roth deferrals.1 Unlike the Roth IRA, this new plan feature does not take income limitations into consideration, thus allowing people that were previously unable to contribute to Roth IRAs to use the Roth deferral feature in their employer-sponsored plans.

Now that employees can either make traditional pre-tax deferrals or after-tax Roth deferrals, how does one decide which option to choose? Here are a few considerations to take into account when deciding whether a traditional or Roth deferral is the better choice for your situation.

traditional-vs-roth-considerations

Tax Bracket

Typically, Roth deferrals are more beneficial for investors that fall into a lower marginal tax bracket. This often applies to employees that are just starting their careers.
Traditional deferrals, on the other hand, are typically better for people that are in their peak earning years, because they can benefit from a tax reduction now.

As your income increases — along with your tax bracket — you should review if it would be more beneficial to pay the tax on the Roth deferral or take the reduced tax liability now via the traditional deferral. If you hold off on withdrawing funds until you’re in retirement, you may fall into a lower income tax bracket than you’ll have during your working years. In this case, a traditional deferral could be a better choice.

Time Horizon

The more time you have before withdrawing funds from your account, the more beneficial a Roth deferral can be. Someone who is close to retirement may not benefit as much from a Roth deferral, because the time period for the funds to grow tax-free isn’t long.

Estate Planning

A Roth deferral can be a great estate-planning technique. Traditional/Roth 401(k) and 403(b) plans and IRAs all have required minimum distributions (RMDs), or the minimum amount you must withdraw from your retirement account each year.2 Roth IRAs, on the other hand, do not. If you rolled over the Roth deferral portion of your employer-sponsored plan into a Roth IRA, a RMD would not be due for that portion. This technique can help preserve that balance and keep it growing tax-free for the next generation — a huge benefit!

Charitable Intent

If you have charitable intent and believe that your donations will come from your employer-sponsored plan, then a traditional deferral may be the better option, as it can lower your tax liability. That means the recipient charities won’t pay tax, either.
Choosing the Roth deferral wouldn’t make sense in this case. It would require you to pay taxes and then gift the funds to a charity, which wouldn’t pay a tax on the amount.

As you can see, the choice is not always clear and simple, and there are many factors at play. Remember to review your situation periodically to reaffirm if a traditional or Roth deferral makes financial sense. And, if you’re still unsure which option provides the best fit for you, try consulting a financial advisor.

 

Hewins Financial Advisors, LLC d/b/a Wipfli Hewins Investment Advisors, LLC (“Hewins”) is an investment advisor registered with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. Hewins is a proud affiliate of Wipfli LLP. Information pertaining to Hewins’ advisory operations, services and fees is set forth in Hewins’ current Form ADV Part 2A brochure, copies of which are available upon request at no cost or at www.adviserinfo.sec.gov. The views expressed by the author are the author’s alone and do not necessarily represent the views of Hewins or its affiliates. The information contained in any third-party resource cited herein is not owned or controlled by Hewins, and Hewins does not guarantee the accuracy or reliability of any information that may be found in such resources. Links to any third-party resource are provided as a courtesy for reference only and are not intended to be, and do not act as, an endorsement by Hewins of the third party or any of its content or use of its content. The standard information provided in this blog is for general purposes only and should not be construed as, or used as a substitute for, financial, investment or other professional advice. If you have questions regarding your financial situation, you should consult your financial planner, investment advisor, attorney or other professional.
OneBite Editorial Staff
OneBite Editorial Staff

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Traditional vs. Roth Deferrals in Retirement Plans

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