Clients often ask us whether they should set up their 401(k) as a traditional tax-deferred account or a Roth. Like so many financial decisions, the answer depends on your personal circumstances.
As a refresher, Roth contributions are funded from taxable income, meaning you pay taxes on them up front, but never again. Tax-deferred contributions, on the other hand, are contributed without tax payments. Instead, they’re taxed on the accumulated gains after they’re distributed—normally in retirement.
Most advisors suggest using this rule of thumb: If you are young or in a low marginal tax bracket, take the Roth option if it’s available. Later, no matter how high your income soars, you’ll never have to pay taxes on these investments again.
But if you are a high-income earner, put the majority of your contributions into a tax-deferred account. After you retire, you’ll likely be in a lower tax bracket, and your contributions will therefore be taxed at a lower rate.
We think the rule of thumb is mostly correct, but there are a few other important considerations.
We have seen clients who have amassed very large tax-deferred accounts for retirement, but hold little in Roth account wealth. The problem with that is, it gives you no tax diversification flexibility after you retire. If nearly all your wealth is locked up in tax-deferred accounts, every single dollar you take out to pay expenses will be taxed as income. If you have large medical bills or purchase a car, you might just be distributing yourself into a high marginal bracket with no way to moderate the tax hit.
But if you diversify your investments across both tax-deferred and Roth accounts, you can pull from either as you wish, managing distributions to minimize your taxable income every year. Remember, tax-deferred wealth is subject to minimum distribution rules, but Roth IRA wealth is not. So building up a Roth will minimize those forced minimum distributions after age 70.5.
Another point to remember is that after you retire, withdrawals from your tax-deferred accounts will increase the tax on your Social Security income. Beyond a certain threshold, they can also raise the cost of your Medicare premiums.
The upshot is, even if you are a high-income earner, you should consider building up some savings outside of tax-deferred accounts—even though it will raise your current tax payments. Tax diversification, like investment diversification, can pay off in spades over the course of your lifetime.
For another view on Roth vs Tax Deferred 401(k) contributions, here are a couple of good reads: Why you might want both a traditional 401(k) and a Roth and Roth 401(k) vs. 401(k): Which is Best for You?