By Allen Giese, CLU®, ChFC®, ChSNC®

Roth or traditional? That’s a question a lot of people wrestle with when they’re deciding how to contribute to their Deferred Comp plan.

For most of you, your plan allows you to put money into either the traditional option, the Roth option, or even split contributions between the two. So the natural question becomes: Which one actually makes more sense?

Let’s start with a quick refresher, because the difference between these two options really comes down to taxes and when you pay them. With the traditional option, your contributions go in pre-tax. That means you get a tax deduction today, which lowers your current taxable income. The money then grows tax-deferred over time. But when you eventually take it out — typically after you leave service or retire — every dollar you withdraw is treated as ordinary income, and you’ll owe taxes at whatever your tax rate happens to be at that time. And that’s the big question mark: What will your tax rate be in the future?

Now, one thing that’s important to remember: We’re specifically talking about government Deferred Comp plans here. These plans have a pretty unique advantage. Unlike IRAs or many 401(k) or 403(b) plans, once you separate from service, you can access the money without the 10% early withdrawal penalty, even if you’re younger than 59½. That flexibility is actually a pretty valuable feature that not many retirement plans offer.

Now let’s flip to the Roth option.

With a Roth Deferred Comp contribution, it’s basically the reverse. Your contributions are made with after-tax dollars, so you don’t get a tax deduction today. But if certain conditions are met — mainly that you’ve had the account for at least five years and you’ve separated from service — your withdrawals can come out completely tax-free. And that includes not only the money you put in, but also all of the investment growth, which over time could be substantial. So the real decision becomes: Is it better for you to pay the tax now or later? And answering that requires thinking a little bit about what your financial life might look like down the road.

Thinking About After-Tax Income

Getting a tax deduction today is appealing. No question about it. But remember that every dollar you eventually pull out of a traditional account is going to be reduced by whatever your tax rate is at that time. Maybe it’s 22%. Maybe 24%. Maybe higher. Tax laws also change periodically, so if retirement is still several years away, nobody really knows exactly what those rates will be.

What that means is if you’re trying to generate a certain after-tax income in retirement, you may need to withdraw more from a traditional account to net the amount you actually want to spend. With a Roth account, on the other hand, the withdrawals — again, assuming the rules are met — come out tax-free, which can make planning your retirement income a lot more predictable.

Tax Brackets, Medicare & Social Security

There’s another angle to consider as well. Taking withdrawals from traditional accounts doesn’t just affect your income taxes. It can also affect other things that are tied to your income level. For example, higher income in retirement could potentially push you into a higher tax bracket in a given year. Imagine you’re living off your pension and maybe some distributions from another retirement plan, and then you decide to take a larger withdrawal from your Deferred Comp account to make a big purchase. That extra income could bump you up into a higher bracket for that year.

It could also impact your Medicare premiums. Medicare uses something called IRMAA — income-related monthly adjustment amounts — and if your income crosses certain thresholds, your premiums go up. In recent years, those thresholds have started around roughly the $109,000 range for single filers, and they adjust over time.

And finally, higher income from traditional withdrawals could also cause more of your Social Security benefits to become taxable. Those ripple effects are something people sometimes overlook. With Roth withdrawals, though, the money typically doesn’t show up as taxable income, which means it generally doesn’t affect those calculations the same way.

What If You Don’t Spend It?

Another scenario we see quite a bit is people who end up not needing to spend all of their retirement accounts. Maybe their pension covers most of their lifestyle. Maybe other investments are doing the heavy lifting.

So what happens if the Deferred Comp account just keeps growing? If that account is traditional, all of that money, including the growth, will eventually be taxable to whoever inherits it. On top of that, the IRS will require you to start taking required minimum distributions, or RMDs. As of now, those generally begin at age 73, although the law schedules that age to increase to 75 starting in 2033.

So if you still have a traditional balance at that point, the IRS will require you to start taking withdrawals — whether you need the money or not. And those forced withdrawals could potentially trigger the same issues we talked about earlier: higher tax brackets, more taxable Social Security, and higher Medicare premiums.

With Roth accounts, there’s a potential advantage. There are no required minimum distributions during your lifetime. That means the money can keep growing tax-free for as long as you want. So, for people who view this money as legacy assets they might eventually pass to their kids or grandkids, that can be a pretty compelling feature.

Which Should You Choose?

The good news is this isn’t necessarily an either-or decision. You can actually split your contributions between traditional and Roth, and many people do exactly that. Having money in both types of accounts can create flexibility later when you’re deciding where to pull income from in retirement.

But here’s the key point: You do have options. And the earlier you think about those options, the more flexibility you’ll likely have. So it may be worth sitting down with someone who understands how all of these pieces fit together — taxes, retirement income planning, Medicare, Social Security, and long-term strategy.

And ideally, that conversation should be with someone who isn’t trying to sell you a product.

I’m talking about a fiduciary financial planner whose job is simply to help you make smart decisions. That’s what we do here. If you’d like to talk through your situation, we’re happy to have a conversation. No pressure, no expectations — just a discussion about your options. You’ll be surprised at what the experience is like when somebody’s not trying to sell you something. Interested in having a chat? Just give us a call.

Thanks for watching and stay safe.

Contact us for your free FRS special risk retirement guide: info@northstarplanners.com or (954) 693-0030.