08 Sep Looking for tax-free retirement income?

Q. Only 10 percent of my savings is in Roths and I want more tax-free money when I retire. I don’t have enough for an IRA but I save the maximum to my 401(k). Should I switch to a Roth 401(k)?
— Saver

A. This is an interesting question, and a common one.

What is a better 401(k) deferral strategy, pre-tax contributions or Roth contributions?

The answer to that question has a lot to do with your specific situation, and both deferral strategies can make sense, said Chadderdon O’Brien, a certified financial planner with RegentAtlantic in Morristown.

“Right now, you are making contributions to your 401(k) on a pre-tax basis, which is nice because you get a full deduction on your tax return each year for the amount you contribute into the plan,” he said. “The trade off, however, is that the contributed amount plus any future growth will be fully taxable as income when distributed from the 401(k).”

By switching your contributions to the plan’s Roth feature, O’Brien said, you’ll no longer receive a deduction on your contributions, but the contributions and any growth attributed to them will be received tax free when it eventually comes out of the plan.

Which makes the most sense for you?

O’Brien offered a few scenarios to help you better understand the implications to each deferral strategy.

Suppose you’re an employee that has a relatively short period of time until retirement, O’Brien said. Upon retirement, you expect your income to be materially lower and as a result, your overall tax rate will be lower.

“Since you are nearing retirement, you may have also reduced the weightings to stock funds in the 401(k) to a more conservative allocation,” he said. “In this situation, continuing with pre-tax 401(k) deferrals probably makes the most sense for you. This strategy allows you to take advantage of the tax deduction today while your tax rate is high and take distributions from the plan down the line when your tax rate is lower.”

On the other hand, suppose you have many years, perhaps decades, before you can realistically retire. You expect to have a higher income as time goes on but it is difficult to determine what your future tax rate might be because you cannot be certain of how much you’ll have accumulated in assets or what the future tax code might look like, he said.

It is, however, probable that your tax bracket may in fact be higher in the future.

“Since you’re relatively young and have a long investment time horizon you also position your 401(k) aggressively,” O’Brien said. “Because of your timeline and aggressive investment allocation, the expected return on this account is higher than that of a more conservative allocation.”

In this situation, O’Brien said, switching your deferrals to the Roth feature might make sense. While you will lose the current tax deduction, the contributions plus all future growth will be received tax free.

“You’ll also be eligible, at some point, to rollover the Roth 401(k) into a Roth IRA and avoid Required Minimum Distributions at age 70 ½ altogether,” O’Brien said. “This can be powerful because it will allow the Roth account to continue to grow on a tax-free basis versus the regular 401(k), which will be required to begin taxable distributions at age 70 ½.”

O’Brien said this decision should not be made in isolation of your overall financial plan.

Pension, Social Security, taxable investments and other retirement income sources available to you should be factored in during the decision making process, he said.

The more retirement income sources available to you, the less dependent you’ll be on your 401(k) (or IRA if you rolled it over), he said. A Roth IRA that is not required to fund retirement living expenses will be left to grow for a longer period of time. Additionally, the tax free withdrawals experienced by the eventual beneficiaries of the Roth IRA can be powerful as well, O’Brien said.

“Generally, it is best to utilize Roth deferrals if you believe future distributions from the account will occur at a tax rate higher than that of what you pay today or if you’re able to defer distributions beyond age 70 ½,” he said. “Otherwise, maintaining your pre-tax contribution makes sense because the deduction today is valuable if your tax rate is lower when you begin distributions.”

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This post was first published in September 2016.