To Roth or not to Roth – That is the question

To Roth or not to Roth – That is the question

August 30, 2023

One of the provisions of the SECURE 2.0 Act (Setting Every Community Up for Retirement Enhancement) was to force high income earners over the age of 50 to save their “catch up” contributions ($7,500 in 2023) into a Roth 401(k) rather than a traditional 401(k).  This provision was set to take effect in 2024.  On August 25th, 2023, the IRS came out and delayed this provision until 2026. This got us thinking, should you save more in a Roth 401(k) or IRA or a traditional 401(k) or IRA?  In this post, we discuss 3 things to consider when choosing Roth or traditional for your retirement savings vehicle.

1. Current vs. Future Tax Bracket

Yes, we know that may sound a little tongue-in-cheek.  However, you can probably estimate what your future income situation will be relative to your current income situation.  Are you going to retire one day?  If so, you will no longer have a salary and thus your tax bracket is likely to drop.  Are you expecting a big promotion soon?  If so your income, and thus tax bracket, are likely to increase.

As a sample, a future tax bracket projection may look something like this:

*for illustrative purposes only.

Truly, this is the main consideration.  The sample above points toward saving more in a traditional 401(k) or IRA.  This is because, this individual’s tax bracket is projected to decrease over time.  This means, in the future, this individual can withdraw funds from their traditional IRA or 401(k) at a much lower tax rate (or even convert these funds to a Roth in the future).

2. Short term income considerations

True planning is not a set it and forget it.  You should review your income situation at least annually.  Are you having a great year income wise this year, but are uncertain about the future?  Perhaps the opposite is true.  Maybe you are not having a good year this year, but expect to have a great year next year.  This can help you come up with a short term plan on where to best allocate your savings.  For instance, if you are having a below average income year (perhaps you lost your job or had some deals fall through at work), it may make more sense to save in a Roth account this year and then switch back to traditional once your income normalizes.

3. Your retirement goals and overall “tax allocation”

The money we are talking about in this post is designed to help you fund your retirement.  Have you thought about what you want your retirement to look like?  Perhaps you desire to retire in a different area of the country with more favorable tax rates.  If you currently live in a state with high personal income tax rates (e.g., California or New York) and want to relocate to a state with lower, or no personal income tax (e.g., Florida or Texas), you may want to err toward putting more in your traditional 401(k).  By doing this you can escape any state income taxes on the money saved in the traditional account (no state income taxes on contributions and no state income taxes when you withdraw the funds while living in a no income tax state).

Do you have a goal of purchasing a second home or other big ticket item at the onset of retirement?  If so, you should consider your “tax allocation”.  That is the breakdown between your traditional assets, Roth assets, and taxable assets (such as a brokerage account).

*For illustrative purposes only

For this individual, 100% of their portfolio is made up of a traditional IRA or 401(k).  If they are planning on a big purchase at the onset of retirement, they could find themselves in a very high tax bracket (and likely even higher bracket than they are now) at the onset of retirement as they withdraw a large sum to fund retirement expenses and their big purchase.  For this individual, it is probably time to start diversifying your savings. 

So, is a Roth or Traditional better?  As with most questions, the answer is “it depends”.  It will depend on a variety of factors specific to your situation and retirement journey.  However, we can help you assess what makes the most sense for your situation but implementing many of the concepts we mentioned in this post.  If you, or someone you know, needs help planning for their retirement, please do not hesitate to contact us.