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.
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.
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.
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!
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.