By Financial Advisor Peter Egolf
Many investors want to know what types of retirement contributions make the most sense at any given time. But they need to figure out which to pick because of all the variables at play (e.g., their income, present and future tax rates, etc.).
Ideally, is there a heuristic or generalized rule that investors can use to make this decision? The answer is yes.
A Roth contribution is an after-tax contribution to an Individual Retirement Account (IRA) or employer-sponsored plan (e.g., 401k, 403b, 457b). Thus, you pay tax on your earnings the year they were made, you contribute money to your retirement account, and it grows tax-free for the remainder of your life. Withdrawals may be tax-free, depending on whether you meet the requirements.1 There are income limits2 for making Roth IRA contributions. There are no income limits for making Roth contributions to employer-sponsored plans.
A Traditional contribution is a pre-tax contribution to your IRA or employer-sponsored plan (e.g., 401k, 403b, 457b). You will receive a deduction3 to your adjusted gross income in the year you contribute. The contribution grows tax-deferred, and you pay tax when you withdraw the money in retirement. The Roth IRA contribution limit is subject to a maximum income and is phased out or completely eliminated if your income exceeds those amounts.
The answer generally is yes.
Households in a low tax bracket (e.g., 10-12%) can benefit from choosing 100% Roth contributions to lock in the low tax rate.
For all other households, consider allocating based on your age. Take your age and add 20 to determine the pre-tax percentage contribution to a Traditional account. The remaining percentage amount is the after-tax contribution to Roth.
Age + 20 = % to Traditional4
So, let’s look at an example. You are a 50-year-old who wants to maximize your 2024 401k contributions. Because you are 50 or older, you can contribute a maximum of $23,000 + $7,500 in catch-up contributions, for a total of $30,500.
Looking at the chart above, you could make contributions as follows:
As we can see above, the rule generally favors making Roth contributions when you are younger and shifting more allocation to Traditional contributions as you near retirement.
Investors should consider many exceptions to this generalized rule in determining how to implement it in their investments. For example, if you expect a sizeable pre-tax inheritance in the future (e.g., if you inherit your grandmother’s $5M IRA), you will want to account for how that would change your total ordinary income tax. Similarly, you may be able to select specific high and low-income years to shift more towards Traditional or Roth contributions.
Another limitation centers around whether or not you have access to an employer-sponsored retirement plan. If you are covered by an employer-sponsored plan at any point during the tax year, your tax deduction for contributions to a Traditional IRA that year is reduced if your income exceeds a certain amount . This can significantly reduce the benefit of contributing to a Traditional IRA, as you could end up contributing post tax dollars to a plan than taxes withdrawals.
Both Traditional and Roth IRAs are subject to contribution limits , even if you don’t find yourself limited by other constraints, which means you may be forced to use a taxable (e.g., brokerage) account for the remainder of your savings.
The future is unpredictable, so diversifying your savings across taxable, pre-tax, and after-tax accounts can help you balance the risks of having all your assets in one taxation style. The critical point is to use each account when it is sensible to do so and avoid allocating to the wrong accounts at the wrong time (e.g., you are in the highest tax bracket for one year and decide to make Roth IRA contributions knowing that you will revert to the lowest tax bracket next year).
At One Day In July, we work with clients to determine where and when to invest their savings to maximize tax efficiency. As fee-only fiduciaries, we put our clients’ interests first. We can work closely with your tax accountant to ensure your investing and withdrawals are tax-efficient. If you want to learn more about being a client, please get in touch with me to schedule a conversation.
1. Earnings and contributions can generally be withdrawn penalty- and tax-free after age 59.5. Withdrawals of earnings must occur at least five years after the beginning of the tax year of your first contribution in order to avoid penalties/taxes. You can also withdraw your contributions from a Roth IRA before 59.5 without penalty.
2. Roth IRA Income Limits 2024 - IRS
3. It’s important to note that Traditional IRA contributions are not always deductible. It will depend on whether you (and, if applicable) your spouse is “covered” by an employer-sponsored retirement plan and your modified adjusted gross income. Traditional contributions to an employer-sponsored plan reduce your current taxable income by that amount.
4. Tax Uncertainty and Retirement Savings Diversification - David C. Brown, Scott Cederburga, Michael S. O’Doherty
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