Roth vs Traditional 401(k)/457(b) when expecting pension income in retirement – how do I choose?

Retirement planning is no longer an easy task. Age, retirement plan options, taxes, and required minimum distributions (RMD) have all made the calculations much more difficult. You just about need a rocket science degree to figure it all out.

The average person, even if they have the basics down, can find it overwhelming. That’s the situation a Redditor on the r/financialindependence subreddit is in. He and his wife expect to retire early in less than 15 years. With current expenses around $65,000 a year, they have about $700,000 saved across their 401(k) and 457(b) plans, Roth IRAs, and Health Savings Accounts (HSA). All of that is supported by a $120,000 per year pension. 

The Redditor wants to know whether shifting their 401(k) contributions to a Roth 401(k) would be beneficial for their financial situation, particularly to manage future tax liabilities from RMDs, given their expected pension income and tax bracket status. He says they expect never to be in a tax bracket lower than 24% due to the pension.

Avoiding the tax man

As I said, it’s complicated. Now I’m not a financial planner or a tax professional, so these are only my opinions, but the Redditor would be wise to adopt a precise withdrawal strategy to minimize the tax hit.

Assuming the couple’s retirement savings are mostly in equities, they should withdraw at least 7% annually from these accounts to keep the balance from growing excessively. If no further contributions are made to traditional accounts, their current $525,000 in savings could grow to about $1.27 million by retirement. 

This means they should shift to Roth conversions for any income above their pension up to age 60, which would allow for more tax-efficient withdrawals in retirement. This withdrawal strategy would support their lifestyle with a healthy 9.4% withdrawal rate from the calculated future balance.

RMDs: The WMDs of retirement planning

However, they should probably stop contributing to traditional accounts, especially since they are close to a balance where 7% annual withdrawal would be necessary to maintain or reduce the account size. The couple should also aim to stop traditional contributions soon, particularly as employer matches typically default to these accounts. 

This means they should lean toward saving traditional contributions for years when their income might push them into higher tax brackets, thus maximizing tax benefits. However, given their current tax situation — being at the lower end of the 24% tax bracket with standard deductions and current contributions — they might only save 2% by continuing traditional contributions, which isn’t significant enough to justify the potential tax burden from future RMDs. 

In short, they ought to be cautious about the growth of traditional accounts, suggesting a strategic pause or reduction in contributions to traditional 401(k) and 457b plans, possibly saving these for higher income years.

Key takeaway

It’s a delicate balancing act when planning for retirement. While the number of options to save money for a secure, comfortable retirement is obviously beneficial, the rules and regulations put in place thwarts the effort to making planning easy.

It’s why consulting with a qualified financial planner and tax advisor has become an essential requirement as you want to make sure you receive all the benefits and money due you. Tax evasion is, of course, a crime, but tax avoidance is perfectly legal and a worthwhile pursuit.