Is Washington’s New Roth Deferred Comp Option Right for You?
Is Washington’s New Roth Deferred Comp Option Right for You?
This fall, WA State Department of Retirement systems will be rolling out an option to make elective deferrals to retirement savings accounts (aka Deferred Comp, DCP, or 457(b) accounts) as after-tax, Roth contributions.
Prior to this, state employees and others served by the DRS Deferred Compensation Retirement plan have been limited to pre-tax (aka as traditional or tax-deferred) contributions to their retirement plans, and the change has many asking if they should utilize the Roth option or continue with their traditional contributions.
For a brief review of account types: traditional contributions are made pre-tax (so you don’t pay income taxes now). They are invested and are only taxed when you take account distributions in retirement. But when you do take distributions, you’ll pay income tax on both the original contribution amounts as well as the investment earnings. Traditional contributions are a great way to lower your current taxable income, but they aren’t tax free. They just defer your taxes to a later point in time.
Roth Contributions are made after tax, which means they don’t lower your current taxable income. But once the contributions are made, they are allowed to grow tax free from that point on until you access them in retirement. When distributions are taken from a Roth account, you don’t have to pay taxes on the distribution, so the investment growth is essentially yours, tax-free.
While there is no single right answer to the Roth vs. Traditional contribution question, there are steps to work through when trying to decide if the new Roth Deferred Comp option is right for you:
Most people served by the state administered DCP program will also receive a Plan 2 or 3 Pension, Social Security (with the exception of those served by the LEOFF program, many of whom are exempt from Social Security), and possibly funds from a Plan 3 TAP Annuity. The combination of these funds means that you will likely have a fairly steady source of taxable income in retirement. It’s a good idea to start by trying to anticipate how much, and if it will adjust/change your tax bracket at all.
A tax-rate calculator can help you get a sense of what income tax bracket you might be in at retirement so that you can compare it to your current tax bracket. If you’re not sure what your current tax bracket is, these days, when you finish preparing your taxes (or get them back from your tax preparer), they typically come with a summary comparison sheet for the last 3 years at the front of the document. At the bottom of that comparison sheet, you’ll be able to find your marginal tax rate to compare it to the projected marginal tax rate shown on the calculator above.
If your tax bracket looks like it will be drastically lower in retirement – that bodes well for favoring traditional, pre-tax contributions, when possible. But for many teachers, state workers, and other public servants who are also good retirement savers, it’s quite possible that your tax bracket may be equivalent to, or in some cases even higher, in retirement. And if it looks equivalent (and none of the other considerations below apply) it’s a good idea to consider using a Roth contribution method for at least half of your ongoing retirement savings. That being said, item 2 below might point you in the direction of directing an even higher percentage to Roth contributions, while item 3 might actually suggest it’s a good idea to wait a few years before starting to make retirement contributions as Roth contributions.
As I mentioned in this article on teachers who may have too much tax-deferred savings, it’s a real possibility for someone who has worked in a state or teaching job and who has saved aggressively for retirement to create a situation where, once Required Minimum Distributions begin, they are catapulted into a significantly higher tax bracket in retirement than they’ve ever been in before.
At that time, for teachers, I recommended considering a Roth 403(b) as a potential alternative savings method, but there really wasn’t a good alternative for state employees. The good news is that with the state’s adoption of the Roth DCP plan, teachers and all others served by DRS and the state DCP plan will now have the option to make some or all of their retirement savings Roth contributions, for many, eliminating the need to go the 403(b) route at all.
A great way to determine how impacted you might be by this phenomenon is to use an RMD Projection Calculator. This will allow you to see how much you will be required to start taking in Required Minimum Distributions in your early to mid-70s. You can add this to the taxable income you’ve calculated above in the tax bracket calculator and see how it impacts your tax bracket. If it looks like the existing savings you have is going to produce substantially more in RMDs than you need, and will drive your tax bracket up even farther, it’s worth considering a full switch to Roth contributions as soon as possible (provided you won’t be significantly impacted by the issues in point 3).
All other things being equal, I tend to favor Roth Contributions as at least an equal portion of retirement savings for most people, unless they are in a marginal tax-bracket higher than 30% currently, or they have a good reason to believe they’ll be in something like the 10-12% tax bracket through most of their retirement. If we pull financial planning out of the hypothetical spreadsheet world and look at it in real terms of real people retiring, I’ve rarely met a retiree who regretted the amount of Roth contributions they made along the way, while many are overwhelmed by the tax implications of large tax-deferred retirement accounts. The truth is, when you’re making money, paying taxes is a pain, but it’s not a source of great anguish for most people. But in retirement, when income is fixed and you’re no longer adding to your investments, bigger than normal tax bills can actually be a source of great mental stress for many retirees because they see the taxes they have to pay pulling from a fixed pot of income that they are not replenishing each year with a salary.
That being said, there are certain situations where your Taxable or Adjusted Gross Income may be just barely qualifying you for a lot of tax breaks (in addition to a generally lower tax rate) that you wouldn’t get if you suddenly started to show even a little bit higher Adjusted Gross or Taxable Income. This is a particularly relevant consideration when you’re getting big tax breaks related to your kids (for childcare, higher education expenses, etc.).
While the details of each of these are too much to get into here (these types of tax breaks phase out at all different income levels, so unfortunately there is no succinct way to explore them all), suffice it to say that it’s worth discussing with your tax-preparer or financial planner the consequences (and potential lost tax-advantages) if you’ve been making fairly substantial pre-tax contributions and suddenly start making those as Roth contributions. Besides just paying taxes on more income, are there other major advantages you might be missing out on if you make this switch from traditional to Roth contributions?
What Else Do You Need to Think About when Switching to Roth Contributions?
Once you’ve decided to make the switch, there are a few things that you may have questions about, or that you’ll want to keep in mind going forward.
For example, if you were making a $1000 per month contribution to a traditional DCP account before, and you decide to make that $1000 contribution to a Roth DCP account going forward, they’ll still only take out $1000 for the contribution, but they’ll have to withhold taxes on the contribution amount, since taxes will be owed this year. Depending on your tax bracket, you could anticipate that your monthly take-home pay on a $1000 contribution might be $100-$300 lower to account for this additional amount you have to pay in taxes now.
In 2023, you can still make a total DCP Contribution of $22,500 (or $30,000 if you are 50 and older). Whether it’s all Traditional, all Roth, or a combination of both, this is still the maximum total amount you are allowed to contribute to DCP per year.
This is a question I receive a lot, and it’s a great point to be aware of. For many folks who have been phased out of their ability to make traditional Roth IRA contributions due to the income limitations, it’s important to realize that these income limitations do not apply to Roth DCP contributions. So, income levels are worth considering because they impact tax brackets, but there’s no point at which you won’t be allowed to make Roth contributions to your Deferred Comp account should you want to do so.
Without knowing exactly what the future brings in terms of income, tax-brackets, and investment growth, it’s hard to know with 100% precision whether Roth Contributions will be the right call for you going forward. That being said, by considering all of the factors above, and working with your financial planning or tax professional, you’ll be able to make a reasonably educated guess about whether you want to take advantage of this new Roth Contribution option being offered by WA State Department of Retirement Systems.
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