When it comes to retirement accounts, Uncle Sam likes his tax money; but he’s somewhat flexible on when you pay him. If you make a tax-sheltered contribution, or if your employer contributes to a retirement plan for you, these contributions are generally pretax. This means you pay taxes on the distributions in retirement, not now. A Roth contribution is just the opposite in that you pay taxes on the contribution now versus in retirement.1
So which option is best for you?
The goal is to pay the lowest tax rate possible. If you are currently in a lower tax bracket than you expect to be in retirement, it’s smart to make Roth contributions.
For example: Sarah is three years into her first job, earning $36,000, and her husband, Bill, is still in medical school. They file a joint tax return and are in the 10 percent tax bracket after deductions. It would be wise to pay the low tax rate now, knowing that they will likely be in a higher tax bracket in retirement.
→ Takeaway: If you are in a low tax bracket now, and believe it may be higher in retirement, then it may be smart to switch from tax-sheltered to Roth contributions.
Let’s fast-forward 10 years down the road: Bill has a successful medical practice and earns a significant income. In this case, they are in a relatively high tax bracket and should consider making tax-sheltered contributions and not switching at this time. They may have less income in retirement and therefore pay a lower tax rate on retirement withdrawals.
→ Takeaway: If you know that your tax bracket is higher now than it will be in retirement, then it would be smart to make tax-sheltered contributions and not switch.
If you are uncertain as to whether you are in a higher or lower tax bracket now relative to retirement (which is a lot of us), then one strategy is to split your contributions. Consider making some Roth and some tax-sheltered contributions. No one knows the future of tax rates, so hedging with both sources may be a good option. Not to mention, an estimated “25 percent of a middle-class American’s 401(k) will likely go toward federal taxes, and an additional piece of the pie will be eaten by state taxes in the 43 states that impose them.”2 So adopting a strategy comprising both Roth and tax-sheltered contributions may be helpful in the long run.
Making decisions about taxes is never an easy or comfortable one. Seeking more information and relying on trusted guidance, however, can go a long way toward creating a brighter tax future. Please consult a tax advisor for any specific questions.
1There are rules that must be satisfied to receive a tax- and penalty-free distribution.
About the author: Kyle Phillip has been a GuideStone® financial advisor for the past seven years. During his free time, Kyle enjoys spending time with his family and running after his 18-month-old daughter.