A question that every financial professional has been asked since the beginning of time is, “should I be making Roth contributions to my retirement account or pre-tax?” It’s an important question. A dollar saved is a dollar earned and many dollars can be saved by utilizing prudent and savvy tax strategies.
Before we get to that, a far more important variable is how much you save to begin with. Your savings rate—especially early on—will have an impact that’s magnitudes greater than this matter. If you’re confident in how much you save, that’s great, let’s tackle this question. If you’re not confident, your time is better spent doing what you can to increase your savings rate.
In this exercise, we’re going to compare Roth and pre-tax contributions specifically in the context of a making that choice in your company 401(k).
The Correct Answer is Unhelpful
The “correct” answer to this question has been and always1 will be: it depends on which is greater—your tax rate now or your tax rate in retirement.
If you could see the future, you would know exactly what your tax rate would be in retirement and you could easily compare the two. If your marginal rate this year is expected to be greater than your marginal rate in retirement, then you should make pre-tax contributions. If lower, make Roth contributions.
But you can’t see the future. You don’t know what your marginal tax rate in retirement is going to be. You can project your income with some degree of confidence, but even that has a lot of uncertainty. And future tax rates are beyond your ability to predict—they could skyrocket, or they could fall. You don’t know.
The “correct” answer is unhelpful because it doesn’t address the uncertainty. Since you can’t answer the question about when your tax rate will be greater, you’re still left with your original question: “So should I do Roth or Pre-tax?”
The Case for Roth Contributions
In our experience most retirement nest eggs skew heavily towards pre-tax money. This makes sense as most retirement account arrangements that folks take advantage of are pre-tax. This is the default option (sometimes the only option) for your employee 401(k) contributions. Any retirement contributions your employer makes on your behalf are pre-tax—matching, profit sharing, pension, etc. If you’re self-employed and you save for retirement in a SEP IRA, those contributions are pre-tax.
Roth accounts, on the other hand, are newer to the scene and there are far fewer ways to accumulate Roth savings. You’ve got Roth IRAs and Roth 401(k)s—that’s it. Consequently, the Roth bucket is nearly always underrepresented in a typical retirement portfolio.
Every investor knows the benefits of diversification when it comes to your investments. It’s also important to diversify the tax treatment of the savings in your nest egg. Doing this will allow you to exert greater control over your tax rate in retirement because you’ll have multiple “buckets” to pull from when making withdrawals.
When to Roth and When Not to Roth
I’m not advocating for making Roth contributions over pre-tax in every circumstance. Even with the uncertainty of future tax rates, there are times when you can be confident that your tax rate in the current year is likely going to be higher than in the future.
When you’re in the prime of your peak earnings years, it’s unlikely your income will be greater than that in retirement. You should make pre-tax contributions. When your income places you in the top two marginal tax brackets (greater than $207,350 for single filers, twice that for married filing jointly), you should make pre-tax contributions.
But when it’s a close call about which is greater, current or future rates, we recommend Roth contributions. When you’re young and not yet in your peak earnings years, make Roth contributions. If you’re nearing retirement and you’ve scaled back in time and income, make Roth contributions.
In other words, tie goes to the Roth.
Unless, like Tom Cruise in Minority Report, you’ve got access to a PreCog who can tell you what your future holds, you can’t know whether your tax rate now will be greater than your tax rate in retirement. You will have uncertainty. The best way to deal with that uncertainty, in our opinion, is to begin diversifying your nest egg by making Roth contributions.
1 at least under current legislation!