2Q2018  |  All Ages

Saving for Retirement: Pretax Contributions and Roth

Many people have at least heard the term “Roth”, but many still don’t know that Roth accounts provide a choice on whether to pay taxes now or later, whether saving through an IRA or at work through a 401(k). If you want to pay taxes today, the Roth account is your answer.

The traditional advice says it’s better to save as much as you can today and pay taxes tomorrow. That seems especially true during peak earning years when you’re paying higher federal taxes. This line of thinking reasons that when you retire, your earnings drop significantly. As you take money from your retirement nest egg, your lower income will result in a lower tax bill. But is this the best advice? Are taxes high right now? Are there other factors to consider?

The chart above provides two pictures related to taxes. The first graph shows the top tax rate at or above 90% in the 1940’s and 50’s. You may be aware that under the new tax law, effective for tax year 2018, the highest rate is 37% (down from 39.6%). To be fair, the tax code in the 40’s and 50’s contained numerous deductions, which allowed high income earners to avoid some of these oppressive tax rates. But the question one has to ask, especially with $21+ trillion in U.S. federal debt and another $3+ trillion in state and local government debt: “Are taxes high right now or low?” For many familiar with the history of the U.S. Tax Code, the answer is not complicated: “They are relatively low.” The second chart shows that the highest tax rates have tended to decline in recent years (since 1979), when compared to the longer term, back to the World War I era. With the debt just mentioned, an aging workforce and more Baby Boomers hoping to retire, one must question whether the trend toward lower taxes is sustainable.


One key to success that many experts share and many mutual fund investors already know is the idea of diversification. The cliché about putting too many eggs in one basket reveals a common insight that helps illustrate the notion. People invest in a mutual fund, like a “500” index, to avoid picking one particular company, watching it struggle and losing a lot of money on that single business. Likewise hedging a bet on tax rates may also make sense. Even in your peak earning years, it may be prudent to pay some tax now by investing through a Roth account. If more ordinary conditions persist with the economy and in Washington D.C., allowing taxes to stay about where they are today, you may not accumulate quite as much in your account. But if the ordinary does not remain – and there are reasons for doubt – your tax hedge may prove very important. Asking your tax professional for clear advice is a good place to start your considerations.

Peak Earning Years.

What about workers who will pay 12% (adjusted earnings up to $38,700–single and $77,400–married) under the new tax laws? For those with the budget and discipline to save, the tax advantage is clear. Especially when one considers social security income in retirement (which is taxable), capturing the opportunity to pay taxes at 12% (or even 22% – the next highest bracket) is an advantage that may be hard to replicate in the future. And here’s a clarifying point on tax brackets: there’s a common misperception that once you cross a tax bracket threshold, you graduate, so to speak, to the next bracket and pay that rate on all of your income to the federal government. That’s inaccurate. For example, let’s consider Jenny. She’s single, and after deductions she will earn $52,000 in 2018. Under the new tax law, she will be taxed as follows:  10% for her income up to $9,525; 12% on her income from $9,525 to $38,700; and, 22% on her income from $38,700 to $52,000. All in, that gives her a blended tax rate of just over 14%. Relatively low and, with adjusted income of $52,000, let’s hope she’s finding a budget allocation to savings.

Why Roth at Work?

Roth accounts inside your 401(k) work differently, compared to an IRA. As many know the maximum contribution amount inside the 401(k) is much greater: $18,500 versus $5,500 for an IRA. But there’s another important point. Roth contributions to an IRA can be restricted or, at higher income levels, disallowed. The Roth 401(k) however is available to all retirement plan participants at work, regardless of income level – when a plan offers the Roth feature. Roth accounts, both 401(k) and IRA, have another interesting and potentially valuable feature. Unlike traditional accounts, which receive pretax dollars and are fully taxed when taken out (both contributions and earnings), ‘qualified’ distributions from Roth accounts are not taxed (neither the amount contributed, nor earnings). In effect, the Tax Code rewards you for paying taxes now, in the Roth account, by letting you take your earnings tax-free later. That’s a powerful incentive.

In Conclusion.

Paying taxes today with respect to your retirement savings may pay dividends in the future and considering that choice is worth the time invested. Do you know whether your retirement plan offers Roth? If not, please call your plan’s recordkeeper or check with your HR team. If your retirement plan offers Roth or if you think a Roth IRA makes sense, your next call should be to set some time with your tax professional.

Mike Smoots, J.D.
ERISA Counsel
[email protected]

Chart: J.P. Morgan Guide to Retirement 2017

Advisory services offered through Prime Capital Investment Advisors, LLC. (“PCIA”), a Registered Investment Adviser. PCIA: 6201 College Blvd., 7th Floor, Overland Park, KS 66211. PCIA doing business as Qualified Plan Advisors (“QPA”).

This commentary is provided for information purposes only and does not pertain to any security product or service and is not an offer or solicitation of an offer to buy or sell any product or service.

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