Roth or Tax-Deferred Contributions: It Depends on Existing Balances!

Quick housekeeping note: I’m taking some time off for the holidays, so there will be no article next week. So on that note, Happy Holidays and Happy New Year to each of you, and thanks for reading!

Today’s article was inspired by a few recent online discussions (and one article) I encountered during open enrollment season, all of which made the same mistake when discussing what type of retirement account to contribute to each year. Specifically, they did not speak at all to the question of what the household’s retirement account balances already look like. It’s such a simple point, but it’s often left out.

People almost always ask about current income level, which is relevant. But we need to know more than that.

Example: Beth and Brian are married filing jointly, in the 24% tax bracket. Most of their income this year is in the form of W-2 wages.

Tim and Tiffany are also married filing jointly, in the 24% tax bracket. Most of their income this year is in the form of W-2 wages. In fact, everything about their income and deductions for this year is identical to Beth and Brian.

But Beth and Brian are age 60. They’ve been maxing out their tax-deferred accounts for 30 years. They’ve had a mostly-stock allocation this whole time, and now they have about $3.5 million in tax-deferred accounts.

Tim and Tiffany, on the other hand, are age 35. They’ve been making Roth 401(k) contributions and Roth IRA (or backdoor Roth IRA) contributions through their whole careers so far. They have a considerable amount of Roth savings and literally nothing in tax-deferred accounts.

Both households are in the 24% bracket, so they’d each get the same amount of tax savings this year from making deductible/pre-tax 401(k) contributions. But Beth and Brian, with their large tax-deferred balance, are already going to have a significant amount of taxable income in retirement, which makes Roth savings start to look better. Tim and Tiffany, on the other hand, will have almost no taxable income in retirement if they continue along their Roth-only path. At some point (perhaps now) it makes sense to start making tax-deferred contributions, so they have income to “use up” their low tax brackets in retirement.

Every decision should be made “at the margin.” When deciding whether to contribute to Roth or tax-deferred accounts, what we want to know is: if you make this contribution as tax-deferred, what would be the tax rate that you’d pay on these dollars and the associated growth when they come out of the account later. All else being equal, the more money you already have in tax-deferred accounts (and, to a lesser extent, in taxable accounts), the higher that tax rate will likely be — and the more sense it makes for this contribution to be made as Roth.