By Allen Giese, CLU®, ChFC®, ChSNC®
By now, I’m guessing most of you are aware that there’s a Roth option to your deferred compensation plan. And most of you have also probably read or heard all the great reasons why you should consider using the Roth side of that account: the tax-free buildup, the tax-free use of the funds in retirement, and the tax-free inheritance for your heirs after you’re gone. And they’re right. Those are awesome! But when is it not a good idea to Roth your deferred comp? I can think of seven reasons.
The Roth option in your deferred comp, or for that matter, any other retirement plan you or your spouse may have, can be a smart move in some cases, depending on your own financial situation both now and in the future. But here are some reasons you might want to opt for the traditional, or pre-tax, side instead of the Roth option.
1. Tax Brackets
Traditional pre-tax contributions lower your taxable income today. So if you’re in a high tax bracket today, like maybe something in the 30s, and you expect to be in a lower tax bracket during retirement, deferring taxes until then could save you money overall.
For example, you have high income now and are in the 35% bracket. In retirement, you calculate you’ll be in the 22% bracket. Paying taxes now via Roth contributions could result in higher lifetime taxes, especially if your investing doesn’t go so well.
And, of course, all this is assuming tax brackets don’t change much between now and your retirement.
2. More Take-Home Pay
Since Roth contributions are made after taxes, they reduce your take-home pay more than traditional pre-tax contributions. So, opting for pre-tax contributions means you’ll have a bigger net paycheck than if you put the same amount into a Roth contribution.
Here’s a simple example. Let’s assume you’re deducting 20% from your paycheck for taxes and contributing $500 to your deferred comp plan. Looking at a Roth contribution, that means if you have a $3,000 paycheck and deduct 20% for taxes, that leaves you $2,400. Then you contribute $500, and your take-home pay is $1,900.
But if you contribute that $500 before taxes, you’re only getting taxed on $2,500, so your take-home pay is $2,000, or $100 more. That extra $100 might go a long way toward funding any debt payments, managing living expenses, or funding other priorities.
3. You Need the Tax Deduction Now
Contributions you make to the traditional or pre-tax side can help reduce your adjusted gross income, or AGI, which could potentially qualify you for other tax credits or deductions, like the Child Tax Credit, student loan interest deduction, or even health insurance subsidies.
So if there’s tax credits or deductions that you could be getting but aren’t because your income is just a little too high, well, maybe making pre-tax contributions to your plan is a good thing that’ll help you qualify for those benefits. Because Roth contributions don’t reduce your AGI.
4. Already Have Roth Savings
What if you already have significant Roth savings, either through previous Roth IRAs or maybe previous Roth 401(k)s or maybe even a spouse’s Roth accounts? It might make a lot of sense to diversify your tax exposure by contributing to the pre-tax side now.
It is nice in retirement to have a mix of taxable, tax-deferred, and tax-free accounts. It gives you more flexibility to manage your taxes more effectively in retirement.
5. You’re Moving to a Lower-Taxed State
If you’re watching this and happen to live in a high-tax state now but plan to retire in a state with no state income tax, traditional contributions let you defer both federal and state taxes until you’re in a lower-tax environment.
But if you live in Florida, which most of you watching this do, then the opposite is also true. We’re already in a state with no state income tax, so if you plan to retire in a state that does have an income tax, that may actually be a big point in favor of Roth contributions now. I guess my point is, where you live now and where you think you’ll live in retirement actually does make a difference with this decision.
6. You’re Not Passing It On
One of the big benefits a Roth has is that it passes to your beneficiaries tax-free. But if that’s not important to you or a goal of yours, then that’s one big reason not to contribute to a Roth.
It is one of the things, though, that make Roth accounts a valuable estate planning tool because they grow tax-free and can be passed on tax-free to heirs, with some limitations. If your goal is mainly retirement income for yourself, the estate advantages of a Roth might not matter as much.
7. Close to Retirement
If you’re close to retirement, you may not have enough time for tax-free growth in a Roth to pay off. While Roth accounts do grow tax-free, the benefits compound over decades, making Roths more obvious choices for younger workers but something you really should look at and challenge a bit as you get older.
And that’s kind of the point of this video. Like so much in financial planning, the right choice for you depends on what could be a number of factors. At the end of the day, your financial plan—whether you contribute to a Roth or traditional plan or both—it should all reflect what matters most to you, not someone else’s idea of success.
That’s why working with a true professional isn’t just helpful—it’s worth it. Give us a call and let us take the time to understand your goals, your values, and your vision for your future—and help you make it real.
Thanks for watching, and be safe out there!