What to consider when weighing pre-tax, Roth IRAs

Jeff Witz, CFP

Many physicians wonder if they should be making pre-tax or Roth contributions to their retirement plans. Both have potential advantages but often require looking into a crystal ball and envisioning your financial circumstances at the time you retire. Will you still be earning a significant income in retirement from business interests or investments or will your income be minimal aside from Social Security and retirement plan distributions? Choosing between Roth or pre-tax contributions can be overwhelming—no one wants to make a mistake. There are some key differences you will want to consider when making your decision.

Let’s start by understanding the basic concepts of pre-tax and Roth accounts. To compare, let’s break each account type down into 3 phases: the contribution phase, the growth phase, and the distribution phase.

Traditional (pre-tax)

Contribution phase. Money is deposited into the account pre-tax. For employer-provided plans such as 401(k)s and 403(b)s, this means the money is contributed to the account before any federal or state taxes are withheld. If it is a traditional individual retirement account (IRA), you contribute post-tax money but then take a deduction when you file your tax return, which makes the contribution pre-tax. (Note: The ability to take a tax deduction from contributing to a traditional IRAs is phased out at certain income levels if you are a participant in an employer-sponsored retirement plan.) Pre-tax contributions reduce the taxable income that gets reported to the Internal Revenue Service (IRS).

Growth phase. Money is invested and grows tax deferred. This means you can buy and sell and accumulate investment gains without owing tax on those gains. This tax-advantaged feature allows more money to stay in the account and accumulate gains.

Distribution phase. The IRS is patient, not generous. When you take a distribution from the pre-tax retirement account, you must include the full distribution in your reportable income and pay tax on it.

Overview. A deduction to claim on your tax return, investments grow tax deferred, and distributions are taxed at your ordinary income tax rate.

Roth, or post-tax

Contribution phase. No tax benefit is received the year the money is contributed. You are depositing money that has already had federal and state taxes withheld or paid on it. (Note: The ability to contribute to a Roth IRA is phased out at certain income levels regardless of your participation in an employer-sponsored retirement plan.)

Growth phase. As in the pre-tax account, the money is invested. However, instead of growing tax deferred, investments in Roth accounts grow tax free. You can buy and sell and accumulate investment gains without owing tax on those gains. Like pre-tax accounts, this feature allows more money to stay in the account and accumulate gains.

Distribution phase. Since you paid the tax on the front end, distributions from Roth accounts are tax free. You do not have to include them in your reportable ordinary income or pay tax on them, including the investment gain.

Overview. No tax benefits the year the contributions are made, tax-free investment growth, and tax-free distributions.

So which type of contribution may be best for you? If you know or suspect you will be in a lower tax bracket in retirement than you are now, contributing to a pre-tax account may make sense. You will report less income now while in a higher tax bracket and then take taxable distributions at a lower tax rate when you’re retired.

Alternatively, if you know or suspect you may still be in a high tax bracket during retirement, contributing to a Roth account may make sense. This is frequently the case if there are business interests or investments that still provide a high level of income. If there is no clear tax savings benefit by contributing pre-tax, then tax-free distributions from a Roth account may produce a greater tax benefit. Additionally, if you are earning a significant amount in retirement, tax-free distributions from your Roth account may help you stay in a lower tax bracket because they are not counted as part of your income.

Finally, there can often be a benefit to having both types of accounts. It is not uncommon for physicians to have pre-tax money in a 401(k) or 403(b) and have a Roth IRA (using the backdoor IRA process) as well. Having both types of accounts provides options in retirement. Maybe there will be a year when you have a significant amount of income and are in a higher tax bracket. You would not want to take a distribution from a pre-tax account and pay tax at a higher rate. That would be a year to take a tax-free distribution from your Roth account. In another year, you may have very little income and could be in a lower tax bracket. That would be a year to take a distribution from the pre-tax account and pay the tax.

To determine which types of accounts are best for your individual circumstances, we recommend that you speak with your financial professional or certified public accountant.

Effective June 21, 2005, newly issued Internal Revenue Service regulations require that certain types of written advice include a disclaimer. To the extent the preceding message contains written advice relating to a Federal tax issue, the written advice is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer, for the purposes of avoiding Federal tax penalties, and was not written to support the promotion or marketing of the transaction or matters discussed herein.

The information contained in this report is for informational purposes only. Any calculations have been made using techniques we consider reliable but are not guaranteed. Please contact your tax advisor to review this information and to consult with them regarding any questions you may have with respect to this communication.

MEDIQUS Asset Advisors, Inc. does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.