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Cannot contribute to a Roth IRA? Consider Roth(k) Contributions

By Karen DeRose, CFP®, CRPC® & Anthony DeRose, JD*, MBA, CPA*, CBEC®

One of the many questions we sometimes get as advisors is “should I be contributing to a Roth IRA?” Unfortunately, for the vast majority of our clients, our answer is “No.” This answer stems not from whether or not it makes financial sense to do so, but rather because they are simply precluded from doing so by the IRS because their income is too high due to income phase-outs. Those single filers with adjusted gross income (AGI) of $118,000-$133,000 are partially phased out (meaning they can only make partial contributions), and those single filers with AGI of $133,000 are fully phased out (meaning they are simply not allowed to make any contribution to a Roth. For Married individuals, partial phase-outs occur for AGI between $186,000-$196,000, after which full phase-out occurs. However, the answer to our follow-up question may allow for the benefits of a Roth IRA to be realized – does your 401(k) allow for Roth contributions?

The Difference

There are many 401(k) plans that are now being written to allow for Roth(k) contributions, as opposed to traditional contributions (up to $18,000 in 2017). Roth contributions are made on an after-tax basis, and traditional contributions are made on a pre-tax basis. (Your employer will deduct 401(k) contributions directly from your paycheck regardless of whether you opt for traditional or Roth.)

Traditional contributions reduce your taxable income for this tax year. Say you make $150,000 and contribute $15,000 in traditional form to your 401(k) plan. Your taxable income is immediately reduced to $135,000. Furthermore, the money you invest grows tax-deferred until you withdraw it at retirement. At retirement, you pay ordinary income tax on all traditional contributions and any gains.

Roth contributions won’t reduce your current taxable income. But there are no taxes on Roth distributions at retirement. You pay taxes up front, and the rules today state that future withdrawals aren't subject to taxation ever again, both on your contributions and any growth.

Deciding whether to Roth

People who are in their peak earning years just prior to retirement generally stand to benefit most from traditional contributions. In such high earning years, traditional contributions could take you into a lower tax bracket and have a significant impact on your tax bill. When you pull the money out in retirement, presumably you will be in a lower tax bracket, thus you are able to benefit from deferring your taxes (including annual dividends/interest and avoiding the 3.8% ObamaCare surtax on investment income altogether) and a lower tax bill when you begin making withdrawals.

Individuals new to the workforce fall on the other end of the spectrum. At this point in time, these younger individuals (generally) have a smaller income, so contributions are smaller, and tax consequences are smaller as well. During these early earning years, there is less financial gain to move to a lower tax bracket, so for these individuals the Roth(k) may be more beneficial over time, as they are able to better enjoy the power of compounding. When such individuals make distributions in retirement, they will enjoy tax free withdrawals on a large account due to compounding (and a smaller tax bill).

If you’re between 35 and 55, the prudent decision is a gray area, as tax and income situations vary widely. Tax laws may also change drastically by the time you retire, so there isn't a perfect plan for deciding on Roth, traditional, or blended contributions.

You can, however, diversify to mitigate tax risks. In this case, we are not talking about your asset class diversification (large cap, mid cap, fixed income, etc.) we mean tax diversification. You can potentially consider blending your contributions by making both Roth and traditional contributions. This split does not need to be equal – you can shade to one particular type of contribution as you so choose – you simply cannot contribute more than the maximum (again, $18,000 in 2017) between both types of contributions in a given year. If you are younger or have a lower income, you may tilt toward Roth contributions; if you’re nearing retirement or are a higher income earner, reducing your taxable income may be more beneficial and you may tilt towards traditional contributions. But, ultimately, much of the decision hinges on whether you feel more comfortable paying taxes now or later and whether you’re willing to risk tax uncertainty during retirement years in exchange for a beneficial tax situation now.

Tax diversification is appropriate for nearly every retirement investor. The percentage split is the element that will vary based on your personal situation and comfort level. Either way, this is a good time to talk with someone that understands your tax burden and overall financial situation. If you want to discuss this further with a professional, we are here to help – feel free to reach out to either of us!

Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors Corp.

Securities offered through Lincoln Financial Advisors Corp a broker/dealer (Member SIPC) and a registered investment advisor. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors Corp. Lincoln Financial Advisors does not provide legal or tax advice.


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