At Truly Aligned: A Wealth Management Firm, we are passionate about helping our clients make strategic financial decisions that align with their values and goals. One of the most common questions we receive is: Should I make pre-tax (Traditional) contributions or post-tax (Roth) contributions to my retirement account? The answer, as with most wealth management strategies, depends on your current tax situation and your expectations for the future. Let’s explore the options.
Understanding Tax Brackets and Contributions
When deciding between Traditional and Roth contributions, understanding federal income tax brackets is key. The U.S. federal tax system is progressive, meaning your income is taxed at increasing rates as you move into higher brackets. For 2024, these brackets range from 10% to 37%, with distinct thresholds depending on your filing status.
Your current tax bracket—and where you expect to fall in retirement—should guide your decision. If your federal tax bracket is 32% or higher, Traditional contributions may be the better choice. Deferring taxes now at a higher rate can result in significant savings, as withdrawals in retirement are likely to be taxed at a lower rate, even considering potential future tax increases. If your current tax bracket is 24% or lower, Roth contributions may be more advantageous. Paying taxes at today’s lower rate allows your investments to grow tax-free, maximizing your after-tax retirement income.
The Case for Traditional Contributions
Traditional retirement accounts, such as a Traditional 401(k), 403 (b), 457 (k)IRA, SEP IRA, SIMPLE IRA, or Solo 401(k), allow you to contribute pre-tax dollars. This reduces your taxable income today, providing immediate tax savings. Withdrawals in retirement, however, are taxed as ordinary income.
This option is ideal for wealth management clients who are in a high-income phase (32% or higher tax bracket), expect to be in a lower tax bracket during retirement due to reduced income, or value the immediate tax deduction to optimize cash flow today. Typically, later in their working careers.
For instance, if your primary retirement income comes from Social Security or Roth accounts, withdrawals from Traditional accounts may be taxed at a much lower effective rate. A strategic withdrawal plan, developed in partnership with a wealth advisor, can optimize tax efficiency.
The Case for Roth Contributions
Roth accounts, including Roth IRAs, Roth 401(k)s, Solo Roth 401(k)s, and Roth conversions (transitioning Traditional accounts to Roth), are funded with after-tax dollars. While there’s no immediate tax deduction, qualified withdrawals in retirement are entirely tax-free.
Roth contributions are advantageous if you are currently in a lower tax bracket (24% or below), expect tax rates to rise due to government deficits or other factors, or want to minimize taxes on retirement income.
Roth accounts offer flexibility that traditional accounts do not. For example, Roth IRAs are not subject to Required Minimum Distributions (RMDs), allowing your money to grow tax-free indefinitely. This makes them particularly beneficial for wealth transfer and estate planning strategies.
Automate and Stay Consistent
Whether you choose Traditional or Roth contributions, the cornerstone of a successful retirement strategy is consistency. Automating your contributions ensures you stay on track, regardless of market conditions or life’s uncertainties.
If you’re self-employed, it’s critical to set up a retirement account. Options like a Solo 401(k), SEP IRA, or SIMPLE IRA provide excellent opportunities to save for retirement while benefiting from tax advantages. A wealth advisor can help determine the best plan for your income and long-term goals.
The Power of Tax Diversification
Tax diversification is a powerful strategy to manage taxes in retirement. By splitting contributions between Traditional and Roth accounts, you create flexibility to draw from the most tax-efficient sources in any given year.
For example, you can use Traditional 401(k) withdrawals (taking funds out of the account) in years with low taxable income and tap into Roth accounts in years when additional income would push you into a higher tax bracket. This balanced approach helps hedge against future tax rate changes and allows for more effective wealth management.
Setting Up Your Retirement Strategy with Truly Aligned
At Truly Aligned: A Wealth Management Firm, we take a holistic approach to wealth management. Our wealth advisors don’t just help with investments; we integrate your tax strategy, retirement goals, and estate planning into one cohesive plan. Here’s how we can assist:
- Comprehensive Tax Analysis: We review past tax returns and forecast future income to identify opportunities and optimize your contributions.
- Custom Retirement Plans: Whether you’re employed or self-employed, we guide you in selecting the right retirement account.
- Long-Term Alignment: We help create a tax-diversified retirement strategy that grows with you and aligns with what matters most.
The Bottom Line
Choosing between Traditional and Roth contributions is a pivotal decision that depends on your current tax bracket, future income expectations, and overall financial goals. For individuals in a higher tax bracket today (32% or higher), Traditional contributions often make the most sense. If you’re in a lower bracket (24% or below), Roth contributions can maximize your tax-free retirement income.
Whatever path you choose, consistency and automation are essential. And if you’re self-employed, establishing a tailored retirement account is one of the best investments you can make in your future.
Ready to align your retirement strategy with your financial goals? Contact us at Truly Aligned today to start building a path to a secure and meaningful retirement.