Should you make pre-tax or Roth retirement plan contributions?

Which is the better investment for your retirement funds?

A common question many physicians ask is whether they should be making pre-tax or Roth contributions to their retirement plans. It is not always an easy question to answer. It often requires predicting the future and envisioning your financial circumstances throughout retirement. Is it likely you will still be earning a significant amount of income in retirement from investments or business interests? Will this keep you in a higher tax bracket? Or, will you have more modest income from social security and retirement plan distributions and drop to a lower tax bracket? Both pre-tax and Roth contributions have potential advantages but choosing the wrong one can result in losing some tax benefits. No one wants to make a mistake, and when deciding between the two, there are some key differences you should consider.

First, it’s important to understand the basic concepts of Pre-Tax and Roth accounts. To compare, let’s break each account type down into three phases: the contribution phase, the growth phase, and the distribution phase.

Traditional (Pre-Tax)

Contribution Phase- As the name suggests, the money goes into the account pre-tax. For retirement plans offered through work, money is deposited before any federal or state taxes are withheld, hence the pre-tax label. Traditional IRAs have a little more work that needs to be put in before the money achieves its pre-tax status. You deposit money into the Traditional IRA and then when you file your taxes, you take a tax deduction, which makes the contribution pre-tax. (Note: The ability to take a tax deduction from contributing to a Traditional IRAs is phased out at certain income levels if you are a participant in an employer-sponsored retirement plan). Money contributed on a pre-tax basis reduces the taxable income you report to the IRS.

Growth Phase- Once the money is in the account, it gets invested and those investments grow tax-deferred. This means you can buy and sell an unlimited number of times without owing capital gains taxes on the sale proceeds. This tax-advantaged feature allows more money to stay in the account and accumulate gains.

Distribution Phase- Because you received a tax benefit when you contributed to the account in the form of reporting less income to the IRS in the year you contributed, and you accumulated investment gains on a tax-deferred basis, the IRS is eventually going to want their piece of the pie. The IRS is patient, not generous. When you take a distribution from a pre-tax account, you must include the full distribution as income and pay income taxes on it.

Overview- A deduction to claim on your tax return, investments grow tax-deferred, and distributions are taxed at your ordinary income tax rate.

Roth (Post-Tax)

Contribution Phase- With a post-tax account, you are contributing money that has already had federal and state taxes withheld or paid on it, so there is not tax benefit in the year the money is contributed. (Note: The ability to contribute to a Roth IRA is phased out at certain income levels regardless of your participation in an employer-sponsored retirement plan).

Growth Phase- Once the money is in the account and invested, the investments grow tax-free. Like pre-tax accounts, you can buy and sell and accumulate investment gains without owing tax on those gains. This allows more money to stay in the account and accumulate future gains.

Distribution Phase- Since your contributions were made with after-tax dollars, distributions from Roth accounts are tax free, based on current law. You do not have to include them in your reportable ordinary income or pay tax on them, including the investment gain.

Overview- No tax benefits the year the contributions are made, tax-free investment growth, and tax-free distributions.

So, how do you decide which type of contribution may be best for you? Contributing to a pre-tax account may make sense if you know or suspect you will be in a lower tax bracket in retirement than you are now. This will allow you to report less income in years you are in higher tax brackets and defer paying the tax until you are in a lower tax bracket when you’re retired. This route can require looking into a crystal ball and trying to foresee your income circumstances far in the future. Will you have business interests, investments, or investment properties that will still pay you a significant amount in retirement? Will this result in you being in an equal or higher tax bracket in retirement than you are now? If so, the tax benefit of contributing to a pre-tax account is greatly diminished.

Alternatively, contributing to a Roth account may make sense if you know or suspect you will still be in a high tax bracket during retirement, potentially due to the reasons mentioned above. If there is no clear tax savings benefit by contributing pre-tax, then tax-free distributions from a Roth account may produce a greater tax benefit. Additionally, tax free distributions from a Roth account may help you stay in a lower tax bracket since they are not counted as part of your income.

Why not consider both pre-tax and Roth accounts? There can often be a benefit to having both types of accounts. It is not uncommon for physicians to have pre-tax money in a 401(k) or 403(b) Plan and have a Roth IRA (using the backdoor IRA process). Having both types of accounts provide options in retirement. In years when you have more modest income and are in a lower tax bracket, those would be good years to take distributions from the pre-tax accounts and pay the tax on it. In other years, if you do have significant income and are in a higher tax bracket, you can take a distribution from your Roth account and avoid owing tax on the distribution. Having both types of accounts provides you the flexibility to choose the account to distribute from that is most advantageous for that year’s tax circumstances.

To determine which types of accounts are best for your individual circumstances, we recommend you speak with your financial professional or CPA.

Jeff Witz, CFP® welcomes readers’ questions.He can be reached at 800-883-8555 or at witz@mediqus.com.

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