DeRose Financial Planning: Cannot Contribute to a Roth IRA? Consider Roth(k) Contributions

by admin 11. November 2013 13:41

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One of the many questions we sometimes get as advisors is “Should I be contributing to a Roth IRA?” Unfortunately, for the vast majority of our clients, they are unable to because their income is too high (adjusted gross income limits of $114,000 - $129,000 for single or $181,000 - $191,000 for married for 2014). However, the answer to our next question may allow for the benefits of a Roth IRA to be realized – do your 401(k) allow for Roth contributions?

The Difference

There are many 401(k) plans that are now being written to allow for Roth(k) contributions, as opposed to traditional contributions. Roth(k) contributions are made on an after-tax basis, and traditional contributions are made on a pre-tax basis. (Your employer will deduct 401(k) contributions directly from your paycheck regardless of whether you opt for traditional or Roth.)

Traditional contributions reduce your taxable income for this tax year.   Assume you make $150,000 and contribute $15,000 in traditional form to your 401(k) plan. Your taxable income is immediately reduced to $135,000. Furthermore, the money you invest grows tax-deferred until you withdraw it at retirement. At retirement, you pay ordinary income tax on all traditional contributions and any gains.

Roth contributions won’t reduce your current taxable income. But there are no taxes on Roth distributions at retirement. You pay taxes up front, and the rules today state gains aren't subject to taxation.

Deciding whether to Roth(k)

People who are in their peak earning years just prior to retirement generally stand to benefit most from traditional contributions. In such high earning years, traditional contributions could take you into a lower tax bracket and have a significant impact on your tax bill. When you distribute the money out in retirement, presumably you will be in a lower tax bracket, thus you are able to benefit from deferring your taxes (including annual dividends/interest and avoiding the new 3.8% ObamaCare surtax on investment income) and a lower tax bill when you distribute the money out.

Individuals new to the workforce fall on the other end of the spectrum. Incomes are smaller, so contributions are smaller, and tax consequences are smaller as well. During those early earning years, there’s less need to jump down to a lower tax bracket, so it generally makes sense to make Roth(k) contributions, which can enjoy the power of compounding. When such individuals make distributions in retirement, they will enjoy tax free withdrawals on a large account due to compounding (and a smaller tax bill). 

If you’re between 35 and 55, the prudent decision is a gray area, as tax and income situations vary widely. Tax laws may also change drastically by the time you retire, so there isn't a perfect plan for deciding on Roth(k), traditional, or blended contributions.

You can, however, diversify to mitigate tax risks. In this case, I’m not talking about your asset class allocation—I mean tax diversification. You can blend contributions so that you’re making Roth(k) and traditional contributions. An even split may or may not work well for you. If you’re younger or have a lower income, you may tilt toward Roth(k) contributions; if you’re nearing retirement or are a higher income earner, reducing your taxable income may be beneficial and you may tilt towards traditional contributions. But, ultimately, much of the decision hinges on whether you feel more comfortable paying taxes now or later and whether you’re willing to risk tax uncertainty during retirement years in exchange for a beneficial tax situation now.

Tax diversification is appropriate for nearly every retirement investor. The percentage split is the element that will vary based on your personal situation and comfort level. Either way, this is a good time to talk with someone that understands your tax burden and overall financial situation.

 

Lincoln Financial Advisors does not provide legal or tax advice.
Karen DeRose is a registered representative of Lincoln Financial Advisors Corp.
Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer and registered investment advisor.  Insurance offered through Lincoln affiliates and other fine companies.
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