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To Roth or Not to Roth? It's a Big Question.

We are just a few weeks away from the deadline to make a 2022 Individual Retirement Account (IRA) contribution. As we approach the deadline, I was thinking about the most common questions I hear from clients about IRAs, 401ks/ Thrift Savings Plan (TSP). The two most common questions I hear are:


  1. Should I save with Roth contributions or “pre-tax” (or traditional) contributions in my 401k/ Thrift Savings Plan/ IRA?

  2. What are Roth conversions and should I do them?


Let’s just deal with Question 1 Today


Since the deadline for a Roth IRA contribution is just a few weeks away, let’s deal with the question about whether making Roth contributions is better or worse than making “pre-tax” contributions. We’ll take up Question 2 next week.


First things first. Is a Roth contribution even an option for me?


Some of your decision may be influenced by IRS rules (for IRAs); or by your employer if you have a 401k. There are income limits for Roth IRAs and not all 401k’s offer a Roth contribution option. The TSP does offer a Roth contribution offer and anyone can make Roth contributions to TSP.


If you’re not sure whether you can contribute to a Roth IRA, click here to request an easy-to-follow flowchart that can help you determine whether you can make a Roth IRA contribution for 2022.


Let’s suppose you meet the criteria and can make a Roth contribution to either your TSP, 401k, or Roth IRA. Then the question becomes whether it makes sense for you and your situation.


The "Rule of Thumb"


The “rule of thumb" is that if you believe you are currently in a lower tax bracket than you will be later, then make a Roth IRA contribution today. But, if you believe you are in a higher tax bracket today than you will be later, then make a traditional (pre-tax) IRA contribution.


It makes perfect sense - pay taxes on more income when your tax rate is lower. Simple! The challenge lies in the uncertainty of your future tax bracket relative to your current tax bracket. And what about your tax brackets between now and in retirement?


Simple rule of thumb in theory. Quite complex in practice.


The Military/ Government Advantage


The “good” news is that for most military Service Members and Federal employees who plan to retire with a pension, your future tax bracket relative to your current tax bracket and (the brackets in between) are perhaps a little more predictable compared to those who work outside of the government. If you are someone who plans to retire from the military or Federal government, here are the things you know:

  • If you’re military, you have a decent idea of what your annual income will be each year, including approximate timelines for promotion.

  • If you’re a Federal employee, you have some idea of whether you’re competitive for promotion and a little bit of an idea of when promotions are even possible.

  • You have quite a bit of job security (compared to the average non-Fed/ non-military employee)

  • In retirement, your pension will be at least 40% (but probably closer to 50% or more) of the average of the three years of your highest annual pay,

  • You will collect Social Security (unless you are CSRS) (for everyone else - Social Security seems uncertain but even if there is no fix you are likely to receive at least a portion of your benefit)

  • If you saved any pretax money in TSP or an IRA you will be required to take distributions of that money at either age 73 or 75 and all of that money is considered taxable income when distributed. And don't forget that any government match is pre-tax!

  • The 2017 Tax Cut and Jobs Act tax brackets are set to expire at the end of 2025 (or sooner) so your tax bracket is likely to go up in 2026 (or sooner)

AND

  • The Federal deficit is relatively high which means that higher taxes are likely at some point in the future.

People who work outside of the government/ military generally do not have pensions, generally do not have a structured pay schedule, or promotion schedule, and deal with relatively less job security. If you have a spouse who works outside of the govt/ military, their uncertainty may increase overall uncertainty for your collective tax situation.


Having said all of that, if you are an average military Servicemember or Federal Civilian who plans to retire with a pension, then there’s a solid chance your current tax bracket is lower than the tax bracket you will experience in your 70s (when Required Minimum distributions kick in).


Did you notice the photo with this blog? That’s the annual tax bill profile for a hypothetical GS-13 Step 10 FERS employee who plans to retire at age 57. Celia is age 55, single and made only pre-tax contributions to her TSP. Note her projected annual tax bill during her last 2 working years vs her annual tax bill after she reaches RMD age. Remarkable right?


You are not Celia - your situation is different and you can't draw any conclusions just from this picture. The point is to simply illustrate that a GS13 who contributed just 5% to her TSP (pre-tax) over her entire career is entirely likely to find herself in a higher tax bracket after RMDs begin. Click here to request a copy of the case study.


But won’t I pay more taxes now if I make Roth contributions?


Yes! You will pay more taxes now. But the power of tax planning may not lie in lowering your tax bill ONE year at a time. The power of tax planning is to consider your LIFETIME tax bill and evaluate options that may lower that bill. There are no guarantees but making reasonable assumptions and evaluating a variety of scenarios can help you make a more informed decision and impact on your lifetime tax bill.


How do I decide?


You could just do some napkin math and use the rule of thumb. It’s what the vast majority of Americans do. But, if you’re a little bit of an egghead (you are my people) or you just want some help with an area that’s not your passion and expertise (you are also my people... vehicle maintenance blog), you should speak with a financial planning professional. Financial planners have access to tools and a body of knowledge that can help you consider a variety of scenarios so you can make an informed decision about Roth vs. pre-tax retirement contributions for your specific situation.


To my DIY readers - this might be one area where it makes sense to get a little outside expertise. Some financial planners work with clients on an hourly or project basis so you can get the insight you need without a commitment or otherwise disrupting your own personal financial planning process.


Tap into the power of tax planning


If you are a DIYer just looking for more info to use in your DIY pursuits, click here to request a few easy-to-follow flow charts to help you make a more informed decision regarding Roth vs pre-tax contributions.


If you are a DIYer looking to decide whether a little extra help on an hourly/ project basis might be valuable, click here to schedule a short call.


If you want to dig into your overall financial situation, including tax planning, click here to schedule a short call.


Subscribe to my blog to be notified when I post about Roth conversions next week.



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