For nearly all of you, in your deferred comp plan, you have a choice to either invest your money in the traditional option or the Roth option—or both, some in each. But what’s the smart play here?

It’s really all about taxes and when you pay them. On the traditional side, you make your contributions on a pre-tax basis, so you get the tax break up front, helping to lower your current income tax bill. Your money grows tax-deferred until you separate from service or retire and withdraw it, at which time everything you withdraw is considered ordinary income, and it’s time to pay Uncle Sam his due based on whatever your tax rate is at that time—which is probably the big unknown, right?

Probably important to note at this point that we’re only talking about a deferred comp plan here, which is kinda unique. With a deferred comp plan for government service employees, there’s no early withdrawal penalties for taking money out at an age less than 59 ½ like there is with IRAs or potentially with 401(k)s or 403(b)s. That’s a big advantage you have, by the way, in your deferred comp plan that few people out there get.

Now, with the Roth option, it’s kind of all in reverse. You make your contributions with after-tax dollars, which of course means you get no current tax deduction. But withdrawals after you separate from service, and assuming you’ve had the account for at least five years, come out tax-free. And that includes all the money that the Roth account may have earned—the gains—which could be considerable!

So it really comes down to deciding when it’s better for you to pay taxes—now or later. And that requires a bit of a look into the future. Here’s a few items you need to consider.

Income After Taxes

A tax deduction today is tempting, but let’s think ahead for a minute. Based on current tax rules, if you withdraw money out of a traditional account, you’ll be reducing it by whatever your tax bracket is at the time. Maybe it’s 22%, 24%, or even into the 32%-plus range. Remember, tax codes do change from time to time, so if your retirement is a few years away or more, it’s kind of anybody’s guess.

But what that means is if you are targeting a certain level of net after-tax income, you’ll have to save that much more to fund your retirement cash flow after taxes.

Higher Brackets, Medicare, Social Security

Another thing to consider is what that additional taxable income from a withdrawal might do to not just your taxes in the future but other stuff that is also related to your income. On the income tax side, having more taxable income may push you up into a higher tax bracket in retirement.

And it could also mean that your Medicare premiums could be more. Under current rules now in 2023, if you’re single and have more than $97,000 of adjusted gross income, your Medicare premiums are going to cost you more.

And lastly, higher income because of that withdrawal from your deferred comp plan could also mean you pay more tax on your Social Security income as well.

None of that would have been an issue if the deferred comp was a Roth deferred comp. Paying the taxes while you were working and putting the money in may make a lot of sense.

Passing It On

What if you don’t spend any of it at all? Just let it grow. First, you realize that all of it, including the growth, is going to be subject to income tax to your heirs when you die and pass it on to the next generation, if you’re in the traditional account. So even your heirs will have to pay the tax on it eventually.

Not so with the Roth—again, assuming you’ve had it for at least five years.

But in addition to that, with the traditional account, the IRS forces you to take out something called required minimum distributions. Currently, the age they start forcing that is 73, but it is due to start at 75 in the year 2033 and beyond.

But nonetheless, if you have a balance in your traditional account at that point, they’re gonna come knockin’ because they, the IRS, want that revenue. And all the stuff we talked about earlier, like potentially getting bumped up into a higher tax bracket, paying more tax on your Social Security benefits, and paying higher Medicare premiums, could all be on the table.

But with a Roth option, provided you roll over the Roth to your own Roth IRA sometime before that required beginning date, there is no required minimum distribution. At least not currently. So, if you’re like a handful of our clients and you’re looking at this money as legacy money to go down to the next generation one day, a Roth has a lot going for it.

Decisions

Hey, this is not an all-or-nothing choice. You can actually do both—and some folks do, and it may make sense for you too.

But here’s my point. You have choices, and you have options. But the longer you wait, the more you may be limiting those choices. So it might be a good idea to sit down with someone who knows and understands what those choices are.

It’s a lot to stay on top of, and it’s what we do here at Northstar Financial Planners—meeting regularly with our FRS retirees to see what changes have occurred in their lives and how it might be impacting their plan.

Interested in finding out more? Give us call! We’d be happy to talk to you about your situation to see if you can benefit from what we do. Thanks for watching, and stay safe!