Pre-Tax or Roth? Building Tax Flexibility for Retirement

Greetings!

Before I get into the content, I have to point out why we should never base a financial plan and/or investment plan on predictions.

At the beginning of 2023 the S&P 500 was right around 3850.

In January 2023, major Wall Street firms put out their S&P 500 year-end price targets.

I will list a few

Barclays: 3,725 - decline of 3%.... Morgan Stanley & UBS: 3,900 - increase of 1%.... Bank of America, Citi Group, Goldman Sachs: 4,000 - increase of 3.8% Wells Fargo & JP Morgan: 4,200 - increase of 9%

As of this writing in early August, the S&P 500 has hovered around 4500 - an increase of nearly 17%.

As of July, now the majority of these firms have suddenly changed their predictions. Investors are still somehow attracted to put their money with these folks thinking the big name firms have some secret formula to success.

It is all guesswork. I advise you to ignore and ideally not do business with them.

The Debate between Pre-tax or Roth

When you sign up for your company’s retirement plan, most plans today have options for contributing either pre-tax or post-tax (Roth).

If you contribute pre-tax dollars, you don’t pay any tax on those dollars today, but will pay the taxes later in retirement.

If you contribute post-tax dollars, you pay the taxes today so that you do not have to pay them later.

When is it better to contribute pre-tax dollars?

When you expect your tax bracket to be lower in retirement than it is now.

It’s a math equation, if your income today puts you in the 30% tax bracket, but you expect to be drawing a much lower income in retirement that would put you in the 20% tax bracket, then the choice is obvious to put money in pre-tax so that you are not paying 30% today and will only pay 20% later.

Another reason might be you intend on passing your pre-tax retirement accounts down to an heir upon your passing. For example, you are in the 30% tax bracket but your grandkid is in the 15% tax bracket, contributing pre-tax would make sense so that you avoid paying the 30% tax and when the account is passed down your grandkid would only be paying 15% tax.

When is it better to contribute post-tax or Roth dollars?

Tax free withdrawals. The biggest advantage of a Roth account is this money will never be taxed again.

If you are earlier on in your career or expect a large increase in income later down the road, it is likely better to contribute post-tax now.

Again, it’s just math. If you are in a 15% tax bracket now, but expect to be in the 30% bracket later, you pay the taxes now at 15% to save 30% later.

Peace of mind. A person might experience a 30-year window of retirement. That is a long time for a lot of potential changes to the tax code during that window. While we may think we will be in a lower tax bracket in retirement, we have no way of predicting what tax rates will actually be. The peace of mind of not having to worry about future tax changes can be very valuable. Especially if you are already on a tighter budget in retirement, not having to worry about a sudden 10% increase in taxes can help you sleep better at night.

No required minimum distribution (RMD). On a pre-tax retirement account, you are required to take a certain amount out every year. This requirement could bump you up into a tax bracket where you lose certain benefits. The Roth account has no such rule.

The question is, well which one is better? In some instances, it’s very obvious. But in most cases, I don’t believe one is necessarily better than the other. There is value in putting money into both plans: 1.) Pre- tax gets you some tax relief today and 2.) Post-tax gets you tax relief you might want/need in the future.

Taking a balanced approach helps mitigate the unknown of what tax rates might be in the future.

Let’s look at an example:

Example 1

A young couple is in the 25% tax bracket today and both are maxing out their 401k at $22,500/year each for the next 30 years.

At 7% growth, they accumulate $4.2million in their pre-tax 401k account by age 60.

They start taking distributions at a rate of 5% of their nest egg which equals $210,000/year of income.

The 1st year in retirement, they are paying 20% in taxes, putting them ahead of the previous 25% tax bracket they were in.

What about RMDs?

By the time they reach the age where Required Minimum Distributions (RMDs) must take place their nest egg has now grown to $5.6million.

At that point, they MUST take $300,000+ out of their accounts, putting them in the 23% tax bracket. Now let’s say one of the spouses has passed away at this point as well, that increases the tax bracket to 30%.

You can see how WITHOUT any potential tax changes they go over the tax rate they were at during their working years.

The Lesson?

When you take a balanced approach throughout your career of saving between both pre-tax and post tax accounts, you have more flexibility in retirement to choose which account to pull from. During a high tax bracket year either due to a passing away of a spouse, a large expense such as buying a RV, or an unfavorable increase in the tax code, you can mitigate this by pulling from your Roth or post-tax account