Wherever you are in your stewardship journey - just starting to invest, mid-career, or nearing retirement - you may have asked the question, which is better? Traditional pre-tax or Roth after-tax retirement accounts? We can place IRAs, 401k, and 403b as all relevant vehicles. If you do an online search, likely most of what you will find is geared towards traditional (pre-tax) retirement accounts, simply for the reasons they state concerning compounding, deferral of taxes, more take-home pay, etc. But is this the whole story? Let's look and see.
One of the big assumptions made about retirement is a) that you are going to spend less - 60-80% of today's paycheck and b) that your tax rate will be lower since you will be spending less in retirement. This is not necessarily true! Often new retirees may spend just as much as they did while working or spend more (at least for a little while), as they are still highly active and now have more free time on their hands. They may have grandkids to spend on, increased healthcare expenses, and travel, among other things. As for taxes, we are in historically low tax rates today and should we assume, they will always stay this way? No, me neither.
What mostly ends up as a deciding factor is take-home pay today versus retirement income tomorrow. If you do all pre-tax investing today, you will have more dollars to spend today because of the tax deferral. The downside is you may have fewer dollars tomorrow (retirement) since you now must pay taxes on all that, and at some unknown future tax rate. We should never forget that embedded in our nice big pre-tax balance is another investor's money (the government). On the other hand, if you do all after-tax investing today, you may have more effective dollars to spend in retirement, but you lose the advantage of tax deferral, and your paycheck is going to be smaller today. The upside of doing this is later we will not ever care what the tax rate is, nor will your heirs (yes, by "heirs" you guess correctly that our decisions today can greatly affect our legacy planning. More on this another time). Here is a fun calculator to do some rudimentary analytics on which way you might go: https://content.schwabplan.com/download/RothCalc/RothCalculator.htm
We can do a lot of math here to show how one way or the other, or a combination of the two, may or may not make better sense, but we will refrain from diving into analytical-land. It first comes down to where you are - the situation you are in, your personal philosophy and future projection of your working and retirement lifestyles. So yes, this means financial planning. Then, understanding this better, we can do the math to figure out the best course of action to take.
Here is an example:
Mike and Susan are in their 30's with three young kids. Mike is employed full time with Susan as a homeschool mom. Income need is higher than normal with a growing family. Mike has a 401(k) at work. Mike contributes at least enough to get the company match in his 401(k) and this is all pre-tax. Mike adjusts his 401(k) contribution to maximize their take-home pay to meet the income need. Susan opens a spousal Roth IRA and they put in $50/month after-tax from their income. Fast forward a few years. Mike's income is now higher, and they can contribute more to retirement than before. So, they have to make a choice. In this case, they decide that they want a balance of pre- and after-tax resources at retirement, so they increase their Roth contributions to max and let Mike's 401(k) contributions grow with his salary. As Mike gets into his 40's and early 50's, they switch his 401(k) contributions to all Roth 401(k). Fast forward again. Now near retirement, they may have an equal amount of pre- and after-tax resources to draw from. They spend some proportion of pre-tax and after-tax dollars and start planning to give away some or all of the pre-tax money to charity as a legacy, which would be tax-free to the charity they choose.
After you read this and think this is a specific situation, that my situation is quite different, or "it depends", you would be correct. It requires some deep thinking and long-range planning, and some foresight to build agility into the plan to adjust as your life adjusts.
If you need help with this brainstorming and planning, deciding on the best investment approaches for you, or other life situation connected with your finances, come talk with us. I am happy to investigate this with you!
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