Should You Bother Contributing to a Pretax 401(k) or IRA?

Key Takeaways

• Traditional pretax contributions to an IRA or a company retirement plan are exclusions from your income that you have to pay back when you take the money out. The only money that can get into a Roth 401(k) or Roth IRA is already taxed money.
• Will the government change its mind and undo the generous provisions around Roth IRAs, where you don’t have required minimum distributions and you have those tax-free withdrawals? CPAs have an old saying: Tax laws are written in pencil. They can change anything. But Ed Slott says that Congress loves Roth IRAs because the government gets its money upfront.
• The government realized that the Roth is good for revenue. It expanded Roth 401(k)s and Roth 403(b)s and more. The government tipped its hand in Secure 2.0 with revenue provisions to enhance the Roth. The government added these enhancements because Roth brings in revenue. We should take advantage of Congress’ shortsightedness. It means paying some tax now but being income-tax-free for the rest of your life, no RMDs, plus 10 years later, after that for your beneficiaries.

Christine Benz: Hi, I’m Christine Benz from Morningstar. Tax and IRA expert Ed Slott is the author of a new book called The Retirement Savings Time Bomb Ticks Louder. In it, he asserts that most people should choose Roth over traditional pretax contributions to IRAs and company retirement plans. He is here to discuss why.

Ed, thank you so much for being here.

Ed Slott: Great to be here, and that’s a controversial statement you just made, which I said.

Pretax Contributions to Retirement Plans vs. Roth Contributions

Benz: To not make those pretax contributions. Well, I want to delve into that. But first, let’s talk about the difference between those traditional pretax contributions that someone could make to an IRA or a company retirement plan and Roth contributions before we get into why you think Roth is better.

Slott: Right. So, let’s talk about the 401(k). Most people notice that better on their W-2. Let’s take a very simple example. Let’s say you make $50,000 and you put $10,000 into your 401(k), tax-deferred 401(k). Your W-2 will show as income, the net, $40,000. You only pay on $40,000. If instead you did the $10,000 to the Roth 401(k), assuming your company has that, most do now, your W-2 will show the full $50,000. In other words, you’re going to pay tax on an extra $10,000 because you put it in the Roth. The only money that can get in a Roth 401(k) or Roth IRA is already taxed money. So that $10,000, in my example, people call a deduction. It’s not really. It’s an exclusion from income, which you have to pay back when you take the money out. So, people say, but I’m in my higher earnings years. Maybe I’m making $200,000, $300,000, and maybe I’m contributing $20,000, $30,000, whatever, to a 401(k) and company and it could be big numbers. I want my income lowered now. You’ll just pay for it later. That’s my point. You’re not really gaining anything, if you believe like I do, the tax rates in retirement, your own tax rates, marginal rates plus the rates themselves may be higher, given our deficit and debt—I always say that, everybody says that. And even when I say it now, I don’t know if Congress is ever going to do anything about it. So, I’m saying it anyway, because I have to believe as an accountant in math. And you see our debt level is currently around $34 trillion. By the time you’re seeing this thing, it could be $35 trillion, $40 trillion, $50 gazillion. I don’t know what it is. But at some point, the whole country is running on a credit card. I have to believe the taxes will have to go up. And Congress, the first source of money they’re going to look for, for revenue is probably going to be in your tax-deferred IRAs and 401(k)s because they know we made that deal with them. That money has not yet been taxed. So, I call it the low-hanging fruit. It’s easy pickings for Congress.

Will Congress Undo the Generous Provisions Around Roth IRAs?

Benz: Well, relatedly, I think one misgiving that I sometimes hear about Roth is will the government change its mind on this and undo the generous provisions around Roth IRAs, where you don’t have RMDs, you have those tax-free withdrawals. What’s your take on that question?

Slott: I love that question. In fact, I address it in my book because I get it in every consumer program because I love Roth. I love the idea of being tax-free, never having to worry about future higher taxes, knowing that money is income-tax-free. So, when I talk about it, I always talk up the Roth in consumer seminars, and there will always be somebody who asks the same question, not as nicely as you asked, but they’ll say, “Oh, but Ed, can I trust the government to keep its word that Roths will always be income tax-free?” And I always answer, no, you can’t trust the government to do anything. As CPAs, we have this old saying: Tax laws are written in pencil. They can change anything. But I’m going to tell you a secret. Congress loves, I mean addicted, loves, loves Roth IRAs. Lucky for us, they’re the worst financial planners on earth. That’s why they love Roths. And you know where I’m going: They love Roths because they get their money upfront.

Benz: Money in the door.

Slott: Right, right. And they only look at 10-year budget cycles. So, they look at the Roths and like, this never has to be paid back. We just get all this money in. And they tip their hands every time there’s a new tax bill. If you remember, back in 2010, before that, you couldn’t even convert to a Roth if your income exceeded $100,000. They eliminated that provision and the floodgates of money, including mine, opened up. I told everybody to take that deal. I always quiz advisors on it when we do our training. And I said, I told you guys that they were to take that deal. Of course, I didn’t know the market. Look what the market did from 2010 to now, I didn’t know that. But I saw the benefits of taking that deal. So, I told them, I converted everything in 2010. And then I asked them, how much tax did I pay? And they said, well, you didn’t tell us your price. I said, zero. And they look, zero? Yes, that was the deal. You paid nothing in 2010, half in 2011 and half in 2012. In other words, the government needed money so badly, they gave everybody an interest-free loan to build a tax-free savings account. It was unheard of.

Why Secure 2.0 Points to Roth Accounts Being Here to Stay

So, when they got all that money in, boatloads, they started saying, “Wow, this Roth thing is good for revenue.” And then you saw them expand Roth 401(k)s and Roth 403(b)s and all of that. But they really tipped their hand in Secure 2.0 in big print. If you look at the actual law, the actual text of the law, this is giant font like “Man Walks on Moon” font from the ′60s in New York time, 1969. They said, “Oh, that was the biggest font ever.” This giant font called “revenue provisions.” That’s where you see all the Roth enhancements. Why do they put that there? Because they put these enhancements in, not because they think people like Roth but because it brings in revenue. So, I just mentioned, there are no more RMDs from Roth 401(k)s. Matching can go in Roth. You have 529 to Roths. Sep Roth IRAs, simple Roth IRAs. They went Roth crazy. They want more people doing Roth. So, I don’t think they’re ever going to change their mind about this because they will kill the golden goose. Now, some people say, well, they could trim around the edges and say, well, you have to take some RMDs, but if they go too far, they will kill the program. So, I think it’s pretty safe. Plus, it’s here now. And my feeling is they would never tax anybody twice. People who have it will be grandfathered, probably, just my opinion. So, I think the Roth is here to stay because it brings in money. We should take advantage of Congress’ shortsightedness. It means paying some tax now but having income-tax-free for the rest of your life, no RMDs, plus 10 years later, after that for your beneficiaries.

Are There Reasons to Make Traditional Pretax Contributions Instead of Roth?

Benz: I know you’ve long been bullish on Roth accounts, but are there any situations where you might say, yes, actually make that traditional pretax contribution and get the deduction? Are there any cases?

Slott: Probably not in that case. I don’t see where it pays to get a deduction when rates are low now. You want deductions when rates are high. If you believe rates will be higher later, you don’t want to have to pay the income. You’re doing opposite tax-planning. Originally, when you started that question, I said there are situations, not to make a deductible contribution, but maybe you already have IRAs tax-deferred. So, there are times you may not want to convert all of it. And there are some times, for example, let’s say you want to do qualified charitable distributions. Remember the whole basic foundation of good tax-planning is to get this money out, this taxable IRA money out at the lowest rates. If you’re charitably inclined and you’re over 70½, you can contribute through the IRA, through these QCDs, qualified charitable distributions, direct transfers, getting the money out at 0%, money you were going to give anyway. That might be a reason to keep some money in traditional IRAs to use for your charitable giving.

Another reason, maybe you’re worried about future medical bills. So, the last thing you want to do is tap a Roth that you already paid tax for medical bills, you might get a deduction but against no income. So, you may want to keep some of the IRA and take some of that IRA income down to pay heavy medical bills. They have to be very heavy because they have to exceed 7.5% of your income, but at least you’ll get a deduction against some of that income. It will be offset. Those are two reasons I can think of to not convert everything.

Benz: OK, Ed, always helpful guidance. You’re always bullish on the Roth, but it’s always great to hear from you.

Slott: I love tax-free. Nobody I ever had that I advise of all my clients over the years that did Roths ever, ever complain. They love seeing their statements. Look at it, it’s all mine. I don’t have to share it with anybody. They don’t even remember that they paid the tax.

Benz: Really good point. Well, Ed, thank you so much for being here.

Slott: Thanks.

Benz: Thanks for watching. I’m Christine Benz from Morningstar.

Watch What Interest-Rate Cuts Mean for Your Retirement Portfolio for more from Christine Benz.