Tax Reform Review: Should You Switch To Roth?
February 23, 2018You’ve probably heard by now that Congress recently enacted a significant tax cut for most of the population. Beyond adjusting for lower withholding rates is there anything else you could consider? What about whether you should be saving into a pre-tax/traditional retirement account or a Roth/after-tax?
Get out your crystal ball
Making this decision is a bit of a prognostication game. If you make pre-tax contributions in order to save money on taxes now, you are locking in the need to pay taxes later. With a Roth 401k or IRA you are accepting the fact you are paying taxes now and electing to not have to pay taxes later. Essentially the decision comes down to when you think your tax rates will be higher.
One popular way to look at this question is to compare the amount of income you generate today vs what you think your income will be in your retirement years. If your income is higher now and rates remain the same then you may assume you can save more in taxes by making the pretax contribution. Conventional wisdom used to say that this was the case for most working Americans.
Things have changed
If you were assuming you would have a lower tax bracket in retirement you may need to rethink that. This most recent tax rate change actually has an expiration date — the new rules are set to sunset by 2026. That means that without a significant legislative move we will go back to the old higher rates. And considering the state of our national debt, social security and other fiscal matters of our nation, that’s very likely to happen.
Lower income may still equal higher tax rates
If the current tax rules can sunset this could mean that even if you have a 20% reduction in income at retirement you may be paying the same or higher tax rate in retirement than you would today. For example, if your income is $100,000 today your current top tax bracket is 24%. Let’s say you retire in 10 years and you anticipate your retirement income to be $80,000. If we go back to the old tax rates as planned, that would put you in the 25% bracket. Lower income could equal higher tax rates.
Roth might make more sense than ever … for now
It doesn’t sound like much, but consider for a moment the full power of Roth. Not only does the money you put in come out tax free, but also any growth on those dollars. Locking in the taxes you pay on that money at low rates could make great sense for people who expect to maintain similar income needs in retirement as they do today, and especially for savers with a long timeline for that money to grow.
For a mid-career person like me, this law change has made the landscape easier to plan for the next few years. It’s even prompted my colleague Kelley to change her retirement contributions from half pre-tax and half Roth to all Roth, despite being in what she considers peak earning years. However, once rates go back up, I imagine she’ll be looking at pre-tax again.
Who it might not make sense for
Despite the fact that tax rates are lower than ever, paying your taxes today on retirement income by using Roth may not make sense for everyone. For example, people in the highest tax brackets may still find their tax rates lower in retirement if they are socking away much of their earnings today and plan to retire at a much lower income in the 5-figure range. It’s best to consult a tax professional or a calculator for an answer specific to your situation.
What if I make too much money for Roth
If you have access to a Roth 401(k) through work, then there’s no such thing as making too much, as income limits don’t apply to 401(k). However, it is true that Roth contributions are limited to taxpayers whose incomes are below the annual limits. There are ways to get around it, but beware potential pitfalls.