For most employer retirement plans, such as a 401k or 403b, you have the option of making either Roth or pre-tax (also known as traditional) contributions. However, not everyone understands the difference between the two types of contributions, let alone the significant implications for their lifetime tax bill (or that of their heirs). In this episode, we dive into a discussion of Roth versus pre-tax contributions, explaining what they are and how they work, as well as sharing some perspective around how to think about the two relative to your own situation, in order to decide which is right for you.
Outline of this episode
- Differences between Roth and traditional contributions [1:54]
- What’s the best option for your situation? [5:44]
- Nothing stays the same...especially taxes! [9:24]
- Leaving a legacy [11:16]
- What if your tax rate doesn’t drop in retirement? [15:54]
- The recap [18:03]
Which type of contribution is best for you?
Before deciding which type of contribution is right for you, the first step is understanding the differences between Roth and traditional contributions. From there, you'll be able to better understand the implications of the Roth versus traditional decision and what's best given your situation.
Most employer retirement plans give you the option to make either Roth or pre-tax (i.e. traditional) contributions. For Roth contributions, you don't receive a tax deduction today, but once the money's in the account it grows tax-free and you never have to pay taxes on it again. Whereas for traditional or pre-tax contributions, you receive a tax deduction today. Once the money's in the account, it grows tax-deferred and when you eventually withdraw it in retirement, you pay taxes on each dollar you withdraw. Therefore, at a basic level, deciding between Roth versus traditional contributions comes down to the timing of when you would like to pay taxes.
Is it better to pay taxes now or later?
Now understanding the difference in tax treatment for the two types of contributions, the most important factor is what your tax rate is today when you contribute the money compared to what it will be in retirement when you withdraw it. Knowing this comes down to choosing whether you want to pay taxes on the money now or later, it’s a matter of comparing your tax rate when you contribute the money to what your tax rate will be when you withdraw it.
Tax rates are based on your income so if you think about the progression for the typical physician throughout their life, there are really three phases. The first is the early years when you're in training and earning that resident or fellow income and your tax rate is the lowest. The second phase is the years spent working as an attending when there's a jump in income and therefore your tax rate. The final phase is when you retire. When this happens, you transition from living on your paycheck from your employer to living on a paycheck generated from your income sources like Social Security and withdrawing from your various investment accounts. For the majority of physicians, there's a drop in your income and tax rate in retirement, although hopefully it settles at a higher level than in training!
For most physicians, your tax rate will be higher during your years working as an attending than it will be in retirement, so pre-tax contributions make the most sense because you're able to receive a text deduction now when your tax rate is higher and then withdraw the money in retirement and pay taxes on it when your tax rate is lower.
Nothing stays the same...especially taxes
This is all based on the assumption that tax rates will remain stable over time, whereas we recognize that they can and do change depending on Congress and legislation. Changes in tax rates will have an impact, but they're also impossible to predict. Lastly, there are certain exceptions or unique situations when it comes to this decision. One of them is if you're planning to leave a legacy and you want to do your heirs a favor by paying the taxes on the money now by making Roth contributions so they don't owe any taxes down the road. Another one is if you're one of the rare people whose tax rate in retirement will be similar to their tax rate while working. If that's the case, it's less obvious which type of contributions is more financially optimal for you.
Resources & People Mentioned
- Download our guide: The Toolkit for Optimizing Your Finances as an Employed Physician
- Download our guide: The Financial Checkup
- Episode #3: 6 Ways to Save on Taxes as an Employed Physician
- Episode #15: How to Minimize Your Tax Bill in Retirement