Roth 401(k) Contributions When In High Tax Brackets: Is It Right For You?

I talk a lot about Roth 401(k)s and IRAs in articles, podcast episodes, and even client meetings. Generally, that message is for someone in their early 20s who is new to the corporate world and probably not making a lot of money.

But is it still a good option for those who are in higher tax brackets? Let’s break it down.

What’s the difference?

IRAs and 401(k)s are offered in two ways: Roth and traditional.

The traditional accounts let you make contributions BEFORE paying any taxes on the money. This lowers your taxable income and increases your contribution. Money in this account will grow over your career, and you will pay taxes on everything you withdraw in the future.

A Roth account does the opposite. You make your contribution AFTER you pay taxes on the money. Your contribution will be smaller because you’re losing the taxed amount, but the money grows and can be withdrawn later without paying taxes again.

Why go traditional?

Most people in higher tax brackets will use the traditional accounts because of the tax breaks. If they contribute enough, they can even knock themselves into a lower bracket. This comes with the assumption that they’ll be in a lower tax bracket in the future, so the taxes they’ll pay on withdrawals will be low.

If you’re in your 30s and you’re not going to touch your 401(k) for 30 years, you’re assuming that your taxes are higher today than they will be down the road and that you need the deduction now.

Is Roth better?

The purpose of a Roth versus a traditional 401(k) or IRA is really to time when you are going to recognize various taxes.

Instead of looking at the tax breaks, the real question is what your wealth building journey is going to look like.

If you’re planning to have more money and more income in retirement than you do today based on your financial plan, the traditional account is just going to compound your taxes later.

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.

The challenge is we don’t know what the legislature is going to do, not only at the federal level but at state and local levels, between now and 30 years from now.

In my opinion, tax rates will likely be higher in 2050 than they are now due partly to the current government deficits and the recent stimulus packages, and also to the cost of aging in this country.

As people live longer, their medical costs increase. That creates a need for additional government revenues in the form of taxation. I don’t think we’re going to see a tax regime much friendlier than the one we’re in.

From that standpoint, the Roth option makes sense at almost any income level.

The lesson:

When deciding between a Roth and traditional retirement account, there is not one answer.

Are you expecting an inheritance or sudden wealth in the form of the sale of a business or some other asset which would predictably make your taxes higher down the road? The Roth makes sense. Do you desperately need a tax deduction because you’re getting clobbered by taxes in all directions? Go traditional.

My best advice is to look towards the future and make the decision that fits your personal situation, and not to base your decision on income alone.

The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regards to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results.

Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Brotman Financial Group, Inc. and BFG Financial Advisors are not affiliated with Kestra IS or Kestra AS.

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