You are on a financial journey. That trip will consist of complex decisions. One of the most challenging issues is determining whether to pay taxes today or defer taxation to a later day. No one wants to pay more taxes today, so the default is to delay the tax expense until later in life. But first, let’s consider a few things.
Tax deferral is the choice to delay paying taxes today. The deferral thought process is rooted in a belief that your tax rate will be lower in retirement than today. This strategy is potentially proper if your income today exceeds the financial requirements to match your standard of living in the future. The act of deferring also ignores the chances for tax rates to increase over time. The scariest part of deferral, in my opinion, is the ignoring of inflation. Even if you happen to live on a fraction of your income today, it does not promise that your future cost will be similar.
Utilizing the Roth option requires that you pay taxes today, but neither you nor your beneficiaries will pay taxes on the contribution or the growth. When choosing to use the Roth, you are wagering that the tax rate will be higher in the future. That is not the only reason to consider the Roth in a 401k plan.
Roth IRA contributions do have income limits. There are no income limitations for Roth 401k contributions, but your plan does have to provide you with the Roth option. The amount you can contribute does not change based on how you want the investment to be taxed today. The same contribution amount is allowed for Roth IRA's and Tax-deferred IRA's. This tax mishap or opportunity remains true for 401k and 403b plans.
Suppose you are a high-income earner, and you believe the tax rates will increase; using the Roth option provides another strategic benefit for your retirement. In that case, you are effectively contributing more to your account than your neighbor who chooses tax deferral today. Both parties are limited to a certain amount, but one has already paid the taxes on that contribution.
Diversification is a bed-rock of all investment planning. Do not overlook the value of tax diversification in your financial planning. Consider the risks of rising tax rates, inflation requiring a greater withdrawal for your income needs at retirement, and never discount the value of being able to make choices in the unknown future.
The diversification target for the families we serve is to have one-third of their nest egg tax-deferred, one-third tax-free by being in Roth IRA's, and the remainder in an account consisting of after-tax resources. This strategy provides choices as to where to withdraw based on a future tax-code.
Tax deferral has been around for two decades longer than the Roth, so older individuals weren't offered the Roth option long enough to develop the best tax diversification. That doesn't mean you should ignore opportunities today. Younger readers, start planning early. Tax diversification is critical and will make your future years more flexible.
Joseph A. Clark is a Certified Financial Planner and Managing Partner of The Financial Enhancement Group, and an SEC Registered Investment Advisor. Contact Joe at yourlifeafterwork.com or 800-928-4001. Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory services can be provided by the Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated. World Equity Group, Inc. does not provide tax. For tax advice consult with a qualified tax professional.