Pre-tax contributions to a 401(k) offer an upfront tax advantage – you receive a tax deduction on contributions, and investment earnings compound tax-free. Taxes are deferred until withdrawals are made. Moog’s retirement plan also offers Roth contributions, which are the opposite – taxes are paid on contributions, but investment earnings and withdrawals are tax-free.
Here are some factors to consider before selecting pre-tax or Roth contributions:
If you expect your tax rate to be lower in retirement, choose pre-tax to take advantage of the current income tax deduction. If you are in a high tax bracket, you may not have the same level of income in retirement. In this case, you may be better off receiving a current tax benefit.
If you expect taxes to be higher in the future, choose a Roth IRA to receive future tax-free distributions. The 2017 Tax Cuts and Jobs Act temporarily lowered tax rates. Assuming rates increase in the future, tax-free Roth distributions would be even more valuable than they are today.
Another consideration is if you plan to move to a new state in retirement. Depending on that state’s income tax rates, your projected retirement tax rate may be higher or lower that if you stayed in New York.
Hedge Your Bets
If there is no clear favorite based on tax-rates, you can hedge your bets by contributing both pre-tax and Roth dollars to your plan. There is a lot of uncertainty on where future tax rates will ultimately land and it is not easy to project retirement income, especially when your future taxable income relies heavily on the allocation between pre-tax and Roth accounts in the first place.
In light of this, tax diversification is always a sound strategy. Having a mix of pre-tax, Roth and taxable (brokerage) assets provides you with the ability to manufacture your own tax rate, as you can choose where you want your income to come from. It allows you to take advantage of tax planning strategies such as Roth conversions, early IRA distributions to reduce future RMDs, or generating capital gains on highly appreciated securities without paying any taxes.
Early Withdrawal Concerns
401(k) plans are be retirement savings vehicles. By design, it is hard to get money out of these plans prior to retirement. You can borrow from your plan by taking a loan from your account, which has to be paid back with interest (which may cause cash flow issues). If you take early withdrawals, you will be subject to a 10% penalty plus applicable taxes, unless you meet one of the qualifying exceptions.
To mitigate the risk of an early withdrawal, you may want to contribute to a Roth IRA. Contributions can always be distributed tax-free, assuming that you’ve had the account for five years. If your income exceeds the Roth income limits, you can utilize the “Backdoor Roth IRA” strategy, where you contribute to a Traditional IRA, then convert the funds to a Roth IRA in the same year. Our team can help employ this strategy to avoid paying additional taxes on the conversion.
If you are a Moog employee and are currently thinking about retirement, we have a plan for you. Ogorek Wealth Management (based in Buffalo, NY) specializes in managing wealth and building retirement plans for Moog employees. We are experts in your benefits plans and will work to give you a seamless transition into retirement.
Learn more about Ogorek Wealth Management by scheduling a time to talk.