One of the most common questions we get from 401(k) participants is whether they should make regular, “Pre-Tax” contributions or ROTH contributions.
ROTH, or Regular?
While we can’t answer that question specifically for you in this article, we can give you some general guidelines for you to consider. As always, feel free to reach out to any of the advisors at Invst if you want some guidance on your individual situation.
What’s a ROTH again?
To recap: Pre-Tax contributions go in to your account before you pay taxes on them and are taxed instead when it comes time to withdraw money. ROTH contributions go in to your account after you pay taxes on them and are not taxed on withdrawal.
So how do I know which to use?
Like most questions worth asking, there are a lot of moving parts to consider before you arrive at a correct answer. Unfortunately, if you Google this question, most articles are will attempt to help by posing a question that you are likely not qualified to answer: “Do you believe taxes will go up or down in the future?”. They are implying that if you believe taxes will go up down the road, you should take the ROTH now. If you think taxes will be lower, then vice versa.
Well, how on earth are we supposed to be able to accurately predict the fiscal environment 20 or 30 years down the road? This is not practical, helpful or realistic. So, what’s a better way to approach this question?
A power position
In hockey, there are moments in a game where one team has a “power play” in effect; this means they actually have more players on the ice than the other team. This seems like it would be a huge advantage and it is; for good teams, nearly a quarter of their goals-scored during a season come from these brief, power-play opportunities.
When it comes to your finances, you want to have as many possible “players” as you can as well so that you can operate from a position of power. We often use the term “buckets” when talking with clients. If you can have multiple “buckets” of money, with each having its own unique set of skills and characteristics, then you’ll be very nimble and effective – you’re able to adapt when circumstances change.
Financially, if we are the proud owners of both ROTH and Pre-Tax accounts, then we can pick and choose where to withdraw money from based on the tax environment we find ourselves in. If we happen to be a in a low, favorable tax environment then we might choose to withdrawal money from our Pre-Tax account and get the tax done & paid. If the opposite is true, we would rely more on our ROTH account and let our Pre-Tax money sit still.
Vanilla and Chocolate
If you’ve ever been at a birthday party and someone asked you “vanilla or chocolate”, you probably know that the best answer is “a little of both”. When we’re discussing ROTH vs. Regular, it’s very similar.
You may not be aware, but you can split contributions between both options. So, for example, let’s say you’re saving 15% and your employer matches 5% – a total deferral of 20% of your income. Well, employer matches are always pre-tax, so to divide this money evenly we could consider splitting our portion of the deferral to 10% ROTH, 5% Pre-Tax. This would make your total deferral 10% ROTH, 10% Pre-Tax and would put you in an adaptable position down the road.
Now, this advice mainly applies to people in the middle. For folks in lower income tax brackets, a ROTH is a great option because the value of a tax-break is lower (since they have lower tax rates). These people know with certainty that they can pay a low tax now, essentially “locking in” that low rate. If rates climb or stay the same in the future, they “win”.
For upper income folks, who are often scrambling for every tax break they can find, it’s normally advisable to rely on a pre-tax account, get the tax break today and figure out tomorrow later. They know that they can get a large break now (since their rates are high) and often are targeting alternative ways of picking up tax advantages.
