Financial advice that is commonly accepted states that we should minimize our current tax liability as much as possible (while adhering to IRS code regulations, of course) and then postpone paying the taxes for as long as feasible. The idea behind this is that by doing this, we can retain more of our money for longer and use it to earn a return. In general, this is accurate, especially if you’re a high earner in a high marginal tax bracket. But I’ll explain why it might make sense for high earners to forgo this strategy and purposefully pay more in taxes now by contributing to their employer-sponsored qualified plans through Roth 401(k) contributions rather than Traditional ones.
For employees in the private sector, 403b plans and 401k plans are the most popular employer-sponsored qualified plans. These are popular because they enable workers to conveniently and affordably save and invest for the future by deducting automatic contributions from their paychecks; they are comparable in many aspects. Additionally, Traditional contributions provide an upfront tax break. Anyone with access to an employer-sponsored plan may contribute up to $23,000 in 2024 and have their federally taxable income reduced by that amount, regardless of whether they itemize or take the standard deduction. Easy to set up – check. Automated contributions – check. Major upfront tax benefit – check. Given all of the advantages of traditional contributions, one might wonder why a high earner would decide against them. The answer is undoubtedly yes. Continue reading.
Choosing between Roth and traditional retirement accounts can be a complex decision, especially for high-income earners. While Roth accounts offer tax-free withdrawals in retirement, traditional accounts provide immediate tax benefits. So, when does Roth not make sense for high-income earners?
Understanding Roth and Traditional Accounts:
Roth IRA:
- Contributions are made with after-tax dollars.
- No tax deduction is available for contributions.
- Qualified distributions in retirement are tax-free.
- Income limits apply for contributions.
Traditional IRA:
- Contributions are made with pre-tax dollars.
- Contributions reduce your taxable income in the current year.
- Withdrawals in retirement are taxed as income.
- No income limits apply for contributions.
Factors to Consider for High-Income Earners:
1. Current Tax Rate vs. Future Tax Rate:
- If you expect your tax rate to be higher in retirement than it is now, a Roth IRA may be advantageous. You pay taxes on contributions now, but avoid them on withdrawals later when your tax rate is higher.
- Conversely, if you expect your tax rate to be lower in retirement, a traditional IRA may be more beneficial. You get a tax deduction now, and pay taxes on withdrawals later when your tax rate is lower.
2. Tax Rate Increases:
- Tax rates are historically cyclical and tend to increase over time. If you believe tax rates will rise in the future, a Roth IRA may be a wise choice to avoid higher taxes on future withdrawals.
3. Income Level and Contribution Limits:
- Roth IRA contributions are subject to income limits. For 2023, the limit is $153,000 for single filers and $228,000 for married couples filing jointly. If your income exceeds these limits, you may not be able to contribute to a Roth IRA.
4. Required Minimum Distributions (RMDs):
- Traditional IRA owners must start taking RMDs at age 73. These withdrawals can push you into a higher tax bracket, potentially negating the initial tax benefit. Roth IRAs do not have RMDs, making them attractive for high-income earners who want to avoid higher taxes in retirement.
5. Access to Traditional Funds:
- If you need access to your retirement funds before age 59.5, you can withdraw contributions from a Roth IRA without penalty. However, earnings are subject to taxes and a 10% penalty.
6. Estate Planning:
- Roth IRAs can be passed on to beneficiaries tax-free, making them an attractive estate planning tool. Traditional IRAs are taxed upon withdrawal by the beneficiary.
When Roth May Not Make Sense:
- Current Low Tax Rate: If your current tax rate is significantly lower than you expect it to be in retirement, a traditional IRA may be more beneficial.
- Limited Contribution Ability: If your income exceeds the Roth IRA contribution limit, you may not be able to take advantage of its benefits.
- Need for Early Access: If you anticipate needing access to your retirement funds before age 59.5, a Roth IRA may not be the best option due to potential penalties on earnings.
The decision between Roth and traditional IRAs depends on your individual circumstances, including your current and future tax rate, income level, and retirement goals. High-income earners should carefully consider these factors before making a decision. Consulting with a financial advisor can help you determine the best option for your specific situation.
Additional Resources:
- Kiplinger: 3 People Who Benefit from a Roth (and 2 Who Don’t)
- Mountain River Financial: 6 Reasons High-Income Earners Should Love Their Roth 401k
Keywords: Roth IRA, traditional IRA, high-income earners, tax rate, retirement, RMDs, estate planning
ENTER THE ROTH 401k/403b
Approximately 80% of these eligible plans currently provide a Roth option for employee contributions. When you owe federal income tax on the money, that’s the primary distinction between contributions made into a Roth 401(k) and a Traditional 401(k). Because your taxable income is decreased by the amount you contribute, you receive an upfront tax benefit when you make Traditional contributions. As an illustration, if you are in the marginal tax bracket for 2032 and make the maximum contribution of $23,000 for 202024, your income tax bill would decrease by $7,360% (20 x 2032 = $23,000) which is a substantial savings to be sure. It isn’t until you begin withdrawing your money (after 59. It is important to note that if you take withdrawals after the age of five, you will be subject to regular income tax at your marginal tax rate for that year.
Contributions made to a Roth 401(k) or 403(b) are taxed differently. For the year the contribution was made, you will be required to pay federal income tax on the amount you contributed. But, if a few prerequisites are satisfied, you won’t have to pay taxes on that money when you withdraw it. Again, this benefit cannot be overstated! If you are in the marginal tax bracket and contribute $23,000 to your Roth account in 2020–24, you will owe $7,360% in federal income tax. However, the IRS will never be able to tax that amount of money or the decades of compound growth it generates over the years.
ARE ROTH 401k CONTRIBUTIONS RIGHT FOR YOU?
Before determining whether to make Traditional or Roth contributions, you should ask yourself: Which is more important, minimizing taxes this year or minimizing taxes over the course of your lifetime? As a CERTIFIED FINANCIAL PLANNERTM professional and general finance nerd, I can tell you with absolute certainty that the answer is to minimize taxes over your lifetime. Most people can figure out the rate they’re going to pay this year fairly easily, so the easiest way to do that is to ask yourself which you think is going to be higher: your marginal federal income tax rate this year or your marginal federal income tax rate when you withdraw your money in retirement. Regretfully, it’s more difficult to predict the rate you’ll pay down the road. That will depend on several factors, such as your retirement income, the sources of your income, and the amount of money in your Traditional IRAs.
Should You Use a Roth 401(k) If You Have a High Income?
Do Roth conversions make sense in the highest tax bracket?
The most clear-cut instance of Roth conversions making sense in the highest bracket is for taxpayers at a level of income and wealth where they can reasonably expect to be in the highest tax brackets throughout their lives. Tax rates may rise in 2026 and are currently at historical lows.
Does a Roth 401(k) have an income limit?
Roth 401 (k)s don’t have an income limit for contributions. You can only make contributions to a Roth IRA if your modified adjusted gross income (MAGI) is less than $153,000 for single filers or $228,000 for married couples filing jointly or a qualified widow (er) for 2023. For 2023, Roth 401 (k)s must take RMDs if over age 73.
Is a Roth 401(k) a good investment?
Even in the high tax bracket, a Roth account might still make sense for you if you’re within the limits and you’re allowed to contribute. If a Roth 401 (k) is offered by your company, there is no income limit. Can it be that simple? Of course not.
Should you choose a Roth IRA if you’re in a lower income bracket?
The Roth option is appealing if you’re in the early stages of your career and are currently in a lower income tax bracket. You can lock in known income tax rates today that could be lower than your future income tax bracket during retirement at a time when you’ll need your savings.