Should I Do Roth or Pre-Tax Retirement Contributions?

[00:00:00] Cameron Valadez
Attention retirement savers. If you don't expect to accumulate tens of millions of dollars in your retirement account, you may want to stop contributing to a Roth. That's right, I said tens of millions. Here's what many people, including many professionals, often miss. There's so much information on the topic of Roth or not. And I'm tired of “the should I contribute to my pre-tax 401(k) or IRA, or should I contribute to my Roth 401(k) or IRA” confusion. So I want to take a moment in this episode to clear things up.

Hello and welcome to Retired-ish. In today's episode, I'm gonna clear up some confusion about how to determine whether or not to contribute to your retirement accounts on a pre-tax basis or a Roth basis, also meaning after tax. Just to let you know, we made a YouTube video of this episode that will walk you through the examples that I'm gonna give in the episode. So, for those of you that are simply listening in, please check out the link in the description. If you want to see me walk through some of those accompanying visuals, it might make a little more sense, but either way, I'm sure you'll learn a lot and hopefully have a better idea of how to think about this moving forward.

Here's the math that most people, including many professionals, often gloss over and don't do. And skipping this one critical component can be brutally expensive.

[00:02:02]
You see, the decision of whether or not to make a Roth contribution versus a pre-tax contribution comes down to one relatively simple thing. Will your tax rate be higher now while you're working and saving and accumulating in your 401(k) or other retirement account, or during your retirement years when you start to spend from your 401(k) or IRA? It sounds very intuitive, but figuring out your potential future tax situation is not as easy as it may seem. Part of it will be completely out of your control, and other parts of it will require some very sophisticated financial planning.

The mistake I often see retirement savers make is that they make the decision of whether or not to go Roth based on the factors that they can't actually control. You see, most people only factor in how the government might change actual tax rates or brackets and policies in the future compared to today, which is anybody's guess. There's no way to actually know that.

For example, I often hear people say with all this government spending and the sky-high debt ceiling, tax rates have to go up in the future. So, of course, I'm better off paying taxes now and going Roth. While this may actually come true for you, it's really an educated guess, and it doesn't factor in your personal financial and tax situation at all in retirement. Your exact situation in retirement might also be fairly unknowable. If you're, let's say, a decade away. That's a long time, but it's something you can actually control and plan for. So rather than speculating on future tax policy, there's a real retirement planning analysis that needs to be done, and that is projecting what your future tax situation might look like in retirement.

[00:04:05]
You may be able to get a basic idea of what things may look like if you ask yourself these three questions. The first is how much will I want to spend or need to spend in retirement? Number two, what sources of income will I and or my spouse expect to have in retirement? For instance, Social Security income, IRA or 401(k) withdrawals, maybe rental income, living off of my employee stock compensation, or maybe a side hustle that I might want to engage in in retirement to stay busy. These are the different types of things that you need to think about. And number three, when will I expect each of these income sources to kick in to come into play? And will some of them eventually go away? Do I plan on selling that rental property and therefore not collecting that rental income? And when am I going to do that? These are all critical questions to figure out the answer to.

Now, before we put all of this together, there's one more critical thing you need to understand about making contributions to a pre-tax or 401(k) or traditional IRA versus their Roth counterparts. Contributions to a traditional 401(k) typically provide tax savings today at whatever your marginal tax rate is, which is the tax rate on your next dollar earned. These contributions come off the top of your income while working, and therefore, you have less income to pay tax on at whatever marginal tax rate you're at. You are deferring paying taxes today, understanding that you will pay taxes when the money is eventually distributed or withdrawn later.

On the other hand, distributions or withdrawals from these pre-tax 401(k)s or traditional IRAs. So when you start to take the money out to spend and live on, those are typically taxed at your effective tax rate in retirement, not necessarily your marginal tax rate, which we will get into a little bit more shortly.

[00:06:07]
For most people saving on their own, these distributions are going to be the primary source of income. And this is where people tend to get tripped up because most people don't have written and implemented financial plans. Let me give you a hypothetical example of all of this to help it make a little bit more sense. If you're a married, high-earning couple and making, let's say $500,000 per year, and you're in the 32% marginal tax bracket today, and in retirement, you expect your only income will be from maybe Social Security and withdrawals from your own retirement savings. Neither of you will have a pension, neither of you expects any sort of inheritance, and you don't want to be managing, let's say, rental properties in retirement.

If you were to contribute to your retirement account on a pre-tax basis rather than after tax in a Roth, you'd save about 32% in taxes on the money you contributed because, at $500,000 in income, you were in the 32% marginal income tax bracket even after the reduction in income from the contribution itself. On the other hand, if you opted to go Roth, you would pay the income tax of 32% today on that contribution amount because again, you're in the 32% marginal tax bracket. You're not going to get the tax deduction today if you go Roth. So if you were to decide officially to do a Roth in this situation, you're essentially saying that you expect the federal income taxes you'll pay in retirement will be equal to or higher than 32% when you start to eventually spend those hard-earned savings.
[00:07:57]
Remember, this is because of our main decision-making factor when deciding whether or not to go Roth. Will your tax rate be higher now while you're saving and accumulating in your 401(k) or higher during your retirement years, when you start to spend from your 401(k) or IRA? In this hypothetical situation that I've laid out, which applies to many people, by the way, you would need to actually withdraw about $1.6 million per year in retirement from a pre-tax 401(k) or traditional IRA to pay that same 32% tax rate.

Just to give you an idea of the wealth you would have to amass to make this realistic. That would require a traditional IRA or 401(k) balance of around $40 million by age 75. Why $40 million by age 75? Well, if you decided not to take any money out of the retirement account until you were actually required to, due to the required minimum distribution rules or RMD rules, your first required withdrawal would be around $1.6 million. That $1.6 million, along with, let's say, a couple taking around $60,000 in Social Security benefits, would be taxed at around 32%. How is this even possible? It's because of something called your effective tax rate, which is essentially the total tax divided by your taxable income. Most high earners who consistently max out these accounts or will accumulate maybe in the neighborhood of 2 to 5 million dollars by their retirement years, typically not 40 million.

Let's say our couple in this situation says they can greatly enjoy a comfortable retirement living on around $20,000 per month after taxes, or $240,000 a year. Keep in mind, we're ignoring state taxes because each state is different.

[00:09:59]
They will get about $60,000 from Social Security and have to take out about $225,000, give or take, from their pre-tax retirement account in order to net around $240,000 after federal taxes.
Here's how.

We have our example. We have our $225,000 in annual IRA withdrawals or 401(k) withdrawals, and we also have $60,000 of Social Security between the two spouses. What you see here is the math doesn't exactly add up. And that's because not all of Social Security is taxable. And so there's a little bit of reduction here in the income. But really, their income is $285,000. However, only 276,000 is being taxed.

Now, as you can see here, right from the get-go, their marginal tax bracket is 24%, meaning if they were to earn any additional dollars or withdraw any additional dollars, and they would be taxed at 24%. But overall, when you measure the total amount in tax they're paying, which is about 43, $44,000, their actual tax rate is only around 18% and that's that effective rate.

So when we scroll down here and we take a look at the tax brackets and their income, you can see here that their retirement account withdrawals make up most of their income. Right, because they took 60,000 of Social Security, and they're getting $225,000 out of their retirement account. And because of the way our tax system works in the United States, that 225,000 they take out, it's getting taxed at multiple different marginal tax rates. Some is taxed at 12%, which right here shows you about 73,000. Some is taxed at 22%, and then there's a small amount taxed at 24%. So as you can see here, most of it is taxed at 22%.

[00:11:58]
And you can also see that over here by looking at the actual tax brackets. However, when we blend all of this together and weight them appropriately, that's how we get to the effective rate of 18%.

Here's the shocking part about all of this. None of that money was taxed at 32%. And in fact, the effective tax rate paid on the money was only 18%.

Now, let's go back and look at the scenario of what it would take to actually pay 32% in taxes. Here's our other scenario, where we said you would have to take about $1.6 million out of your retirement account, including some Social Security, in our situation, in order to pay that same 32% rate that we talked about earlier. So as you can see here, their income is really high, over 1,600,000. And again, it doesn't equal exactly 1,660,000 because 9,000 of that Social Security is actually not being taxed. But you can see over here on the left, these people are easily in the highest tax bracket marginal, which is 37%. However, now you can see that their blended tax rate across all the money is 32%.

So now, when we look at the tax tables again, you can see that all the income over 750,000 and change is actually being taxed at 37%. But just like the other scenario, they also have that IRA withdrawal being taxed at other rates, such as 12%, 22, 24, 32, 35. So again, most of that IRA withdrawal is subject to these really big tax rates. And when we blend it all together, we can get this 32% effective tax rate, which is the actual rate of taxes they're paying. That's a 14% difference in taxes, which is a huge difference on this amount of money, especially each and every year.

[00:14:00]
Now, I want to caveat that in this example, this couple would have to pay surcharges on their Medicare Part B and D premiums once they qualified for Medicare. And that's known as IRMAA: I R M A A. But even after adding those additional premiums into the tax calculation, they still pay far less than 32% in total taxes. That means that the actual federal tax rate in retirement in this example will likely be around 18 to 20%, give or take, not 32. And of course, this could change if the tax policies at the time they start to spend their retirement savings could be much different. But this would still require a substantial increase in the tax rates and or a compression of those tax brackets. This is why you need to have some sort of financial plan that helps you decide what decisions to make over time. It's likely due to changes in your personal situation, investments and retirement, and tax legislation. You will have to adjust your plan in decisions over time. If you just set it and forget it, you could be leaving tens, if not hundreds of thousands of dollars, on the table.

So if you are making Roth contributions to your 401(k) or IRA, you may be in a similar situation where you are likely opting to pay far more in taxes now to avoid paying a much smaller amount in taxes later. And I'd say that's not tax planning, that's burning money. Don't get me wrong, Roth IRAs or 401(k) s can be a phenomenal wealth accumulation vehicle for some, but it can also be a costly mistake for others. The goal at the end of the day is to buy out the government share of your retirement account at the lowest possible price, and you can control the negotiations if you learn how. So I challenge you to question what you've learned about utilizing Roth accounts up until this point and make sure you have a plan.

[00:16:00]
That's a wrap for this week's episode. If you haven't already, subscribe to and follow the show on your podcast app. That way, you can get notified each time we drop a new episode, which is every two weeks on Monday. Also, make sure to find the link in the description for the accompanying YouTube video in order to dive deeper on the topic and get a little bit of a better understanding of what we just went over. And don't forget, while you're there, to subscribe to the channel so you can get notified of each new video we put out. It's a brand new channel, we plan on having a lot of great information put there.

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[00:17:49] Disclosure
Opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual.

To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Contributions to a traditional IRA may be tax-deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 and a half may result in a 10% IRS penalty tax. In addition to current income tax.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 and a half or prior to the account being open for five years, whichever is later, may result in a 10% IRS penalty. Tax limitations and restrictions may apply.

Cameron Valadez is a registered representative with and securities and advisory services are offered through LPL Financial, a Registered Investment Advisor Member FINRA / SIPC.

Tax and Accounting Related Services offered through Planet Business Services DBA Planable Wealth Planet Business Services is a separate legal entity and not affiliated with LPL Financial. LPL Financial does not offer tax advice or tax and accounting-related services.