TLDR: Younger high-earners should strongly consider taking advantage of Roth investment accounts between now and the end of 2025.

THE BACKDROP

Conventional wisdom says that if you’re a high-earner fortunate enough to find yourself in the 24% – 35% federal marginal income tax brackets, you should be working to reduce your taxable income as much as possible in the present year in an effort to minimize how much of your income will be taxed at those higher marginal tax rates. This usually means maxing out contributions to your Traditional 401k/403b accounts and avoiding doing Roth account conversions. In most situations, that conventional wisdom still applies; however, this is not always the case. There is a segment of high-income earners for which adhering to this “wisdom” may mean passing up on an incredible opportunity to take advantage of a very powerful wealth-building and tax-planning strategy. I’m talking about younger high-earners who aren’t planning on implementing the “RE” portion of the FIRE movement (Financial Independence, Retirement Early). While I believe everyone is searching for their own version of Financial Independence, not everyone wants to call it quits at age 50 during their peak earnings years (and those years that bring many successful professions their greatest feelings of self-pride) to play golf all day. I’m going to use this post to explain exactly why these younger high-income earners should seriously consider re-thinking this bit of conventional wisdom, at least until 2026. Let’s not forget, personal finance is exactly that, personal.

ROTH vs. TRADITIONAL – A BATTLE FOR THE AGES

Money that is contributed into any sort of Roth retirement account is money that an investor has already paid income tax on, and importantly, is money that is eligible for 100% tax-free growth and 100% tax-free withdrawal any time after age 59.5, assuming some basic conditions are met. By contrast, money that is contributed into a Traditional retirement account is usually money that an investor has not yet paid income tax on. While that money grows on a tax-deferred basis (free of taxes as it grows) in most cases, 100% of that money will be subject to federal income tax when it is withdrawn from the account. When it comes to deciding whether to contribute to a Roth vs. a Traditional retirement account, or whether or not one should convert money from a Traditional to a Roth account, the simplest consideration to make is to try and determine whether you expect to pay a higher marginal income tax rate this year or a higher marginal rate during your retirement years. If you anticipate paying the same rate or a higher rate in your retirement years, contributing (or converting) to Roth accounts this year would be a better financial decision. If your marginal rate in retirement ends up being lower than your marginal rate was when you made the contribution, then making Traditional contributions would have been a superior choice. If you’re a younger high-income earner, the problem with trying to pick Roth vs. Traditional is that it is IMPOSSIBLE to know what marginal tax rate you are going to end up paying when you reach retirement in 2, 3, or even 4+ decades! Doing so would require you to know, with absolute certainty, your taxable income in retirement, the tax code throughout retirement, your social security benefits, how much money you have invested, which accounts your assets are held in, you cash levels…and a whole lot more. While it’s fairly simple for most individuals to figure out what marginal rate you’re going to pay in the current year, it’s simply impossible to know what your marginal rate will be during retirement. So, why am I suggesting that younger high-earners should strongly consider making Roth contributions to their 401k/403b and/or potentially doing Roth IRA conversions in the remainder of 2024 and in 2025? It’s necessary to start here…

THE TCJA TAX CUTS ARE SET TO SUNSET IN 2026

Most economists characterize the income tax environment from the late 1980s up through 2017 as one with low rates relative to the rest of the 20th century. This holds particularly true for higher-income earners in the upper marginal brackets. Then, on Jan. 1, 2018 the TCJA (Tax Cuts and Jobs Act) went into effect, and as the name suggests, it pushed us into an even lower income tax environment. Higher-income earners enjoyed even further reduced average tax rates, lowered marginal tax rates, and widened tax brackets, all of which were coupled with generous increases to popular tax credits like the child tax credit, and a near doubling of the standard deduction. What was the result? We entered into a historically low tax-rate environment, particularly for higher-income earners, that we are still enjoying today. Importantly, the window on this historically low-rate environment is set to sunset at the end of 2025. Could the folks in power in Washington extend these rates? Sure, that’s possible, and maybe even likely, depending on how things to go in November. But, so is the possibility that Washington enters into a messy quagmire in which they can’t agree to any sort of extension, and rates revert back to pre-2018 levels as scheduled. In such a scenario, a very large percentage of taxpayers who are currently enjoying being in the 24% marginal tax bracket are likely to see their marginal income rates increase 9 percentage points all the way to 33% in 2026 (that’s a 37% bump!). This would be the case even if their taxable income were to remain constant. Similarly, a large percentage of taxpayers who are presently in the 35% marginal bracket are likely to see their marginal rate increase 4.6% to 39.6% starting in 2026 (a 13% bump) even if their taxable income were to remain constant. What does this all mean for these young high-income earners who plan on continuing to advance their careers and their levels of income? It means they have a fixed (and likely limited) window of time to take advantage of the situation and lock in these low rates. If you fall into this segment of high-income earners, and any of the reasons below resonate with you, or sound similar to your financial picture, 2024 and 2025 may very well be just the time to seriously consider increasing how much of your portfolio you have allocated to these 100% tax-free Roth accounts!

1. You’re in a higher marginal tax rate, but you expect your income to go up – Just because you happen to be in one of the top marginal brackets today, doesn’t mean that you aren’t going to bump up into even higher brackets as your career grows and income levels rise. Accordingly, right now might be a fantastic opportunity for you to take advantage of both a historically low-rate environment, and what could very easily end up being a very attractive relative marginal rate as compared to what marginal rates you might experience over the next two or three decades as you grow your career and level of income.

2. You want to have control over your taxes during retirement – If you’re not just a high-earner, but you’re also a prodigious saver who loves long-term compound growth in tax-advantaged accounts, the only way for you to have any degree of control over your taxes during your retirement is to have a proper mix of assets between your tax-deferred accounts and tax-free accounts. Your ability to choose which account you want to pull your income from allows you to effectively control your tax rate each year. You could end up taking out all of your needed income from your tax-deferred Traditional accounts, paying income tax on every dollar withdrawn, and letting your income needs control what marginal rate you end up paying – not an optimal outcome. Conversely, you could take all of your needed income from tax-free Roth accounts, and pay $0 in taxes with a 0% marginal tax-rate – also not an optimal outcome. A third, and most often the best option, is to create an income stream using a mix of both tax-deferred Traditional and tax-free Roth accounts. Often this means taking enough income out of your Traditional accounts such that you fill up your Standard Deduction and the first two or maybe three of the lowest marginal tax brackets, at which point if you needed more income, you would have the luxury of choosing whether you wanted to pay the higher marginal rate on those next dollars by continuing to withdraw from your Traditional accounts, OR whether you would prefer to take those next dollars from your Roth account instead, where you could pull out those dollars 100% free and avoid that higher tax rate entirely. The only way to achieve this incredibly advantageous position is to have established a proper mix between tax-free Roth accounts and tax-deferred Traditional accounts.

3. You prefer making Traditional contributions, but recognize that you could be wrong – The fact is, if you’re focused exclusively on maxing out contributions to your tax-deferred Traditional accounts, it’s because you believe firmly that you will end up being in a lower marginal rate environment during retirement. But, what if you’re wrong? You could end up being wrong for countless different reasons, especially if you’re 20+ years out from retirement. Instead of making a single concentrated bet with this extremely important decision, why not hedge a little just in case? In the world of personal finance, this is basic risk management.

4. You expect tax rates to eventually rise across the board, even if not in 2026 – I’m no macro-economist, nor am I a geo-political expert, but it doesn’t take a genius to look at our current level of national debt, our annual budget deficits (which seem to climb year-after-year regardless of who is in charge in Washington), the state of Social Security and other entitlement programs, the precarious state of our nation’s future creditworthiness, the global conflicts that are presently occurring, other potentially globe-shaking conflicts that seem quite plausible in the near future, and come to the logical conclusion that it isn’t if taxes will eventually go up across the board, it’s when. Even if our current tax rates get extended beyond 2026 and this window of opportunity for building up tax-free Roth accounts ends up being longer than a year (which would obviously be a win to all savers in the short run), if you believe that window will eventually close, it stands to reason that now is still an excellent time to lock in today’s historically low rates and control the tax rate you pay today, before rates do eventually rise (or your income level rises) and the opportunity vanishes. At that point, you will almost certainly want to take full advantage of maxing out your Traditional tax-deferred accounts to dodge those higher rates, and will likely be kicking yourself for not taking advantage of your Roth accounts when the window was open and the proverbial “getting was good”.

5. Behaviorally, you’d prefer to pay tax on the much smaller “seed” during your earning years, as opposed to paying tax on the much larger “harvest” when you’re living off of these accounts – Let’s just assume that you magically know that you’re going to pay the exact same marginal tax rate of 24% this year, as you will throughout all of your years in retirement, starting at age 65. Which of the following would you prefer? Contribute $23,000 to your Roth 401k account, pay $5,520 in taxes this year while you’re still earning an income, and let that money compound at a 9% annualized return over the next 30 years for a 100% tax-free ending balance of approximately $305,000. OR, would you prefer to contribute $23,000 to your Traditional account, save $5,520 in taxes this year, and choose to pay approximately $73,238 in taxes on that same $305,000 account balance when you withdraw those dollars to live off of in retirement? Experience tells me that the overwhelming majority of investors would prefer paying the much smaller tax bill and to do so during their earning years, as opposed to paying a considerably higher tax bill, and pay those higher taxes as you’re living off of these accounts. In fact, I can’t ever recall a client looking back and wishing that they had contributed less to their Roth accounts in the past, regardless of what their marginal tax rate was in those years. The behavioral benefit of knowing that every last penny in your Roth accounts is 100% yours, and yours alone, simply cannot be overstated!

6. Aggressive savers who implement a 100% Traditional contribution strategy over their working years will likely end up with enormous balances in their Traditional accounts at retirement – This may seem obvious, but let’s look at a basic example to see how this can create a serious tax bomb in retirement. Let’s assume a married couple who are both 35-year-old successful professionals. They have high incomes and have thus far contributed 100% of their retirement savings into tax-deferred Traditional accounts. They expect to remain high-earners until retiring at age 65, and as such, plan on continuing with 100% Traditional contributions to their 401k accounts. Let’s assume that as a result of saving aggressively, they have thus far amassed a total balance of $700,000 in Traditional retirement accounts. As savvy savers, both spouses plan on continuing to make the maximum allowed contribution to their 401k accounts every year they are working ($23,000/year in 2024, a figure we’ll hold constant in this example even though in actuality it would go up over the years). If we assume a 9% annualized return on these accounts over this 30-year period, they would have a balance of approximately $15,558,000 in their Traditional accounts at age 65! That’s quite an impressive figure! But, what if, like many prodigious savers who retire before 75 (when RMDs will kick in), this couple chooses to live off of the investment portfolio in their taxable brokerage accounts and other income streams to fund the first 10 years of retirement so that they could enjoy another decade of tax-sheltered growth in their retirement accounts? Even if we assume a more modest 6% annualized rate of return for that decade, the balance of their Traditional accounts would balloon all of the way up to approximately $27,861,000! Based on the current IRS Uniform Lifetime table, that would mean an initial RMD at age 75 of approximately $1,133,000, with that figure increasing each year, thereafter! I obviously don’t know how much the tax brackets will shift upward due to inflation adjustments over the next 30 years, nor can I say what a taxable distribution of that magnitude would do to one’s marginal tax rate. I am, however, confident that the rate at which the brackets will adjust up won’t come close to matching the average rate-of-return that long-term investors are likely to get over that same 30-year period when invested in a diversified low-cost portfolio. I also believe it’s safe to say that this would almost certainly result in a tax nightmare for most retirees! It is crucial that I remind you that these balances are actually very conservative estimates. There are two reasons for this. First, this couple would likely be getting considerable matching dollars from their respective employers which would also go into their Traditional 401k accounts. Second, the maximum annual 401k contribution amount will not remain constant at $23,000 over the next 30 years. In real life, the maximum 401k contribution amount has typically gone up every year or two. If this couple were to continue maxing out their respective 401k contributions each year, they would end up contributing far more over that 30-year period than the static $23,000/year figure that I used in this example. For both of these reasons, the actual Traditional account balances this couple should realistically expect at ages 65 and at 75 would likely dwarf the figures above. As a consequence, their RMDs would then also be considerably higher than the figure above, and their tax nightmare that much worse.

7. Getting money into a Roth account now could save you on Medicare IRMM surcharges in retirement – If your taxable income is above certain thresholds in retirement, you will be subject to increasingly higher IRMAA (Income Related Medicare Adjustment Amount) surcharges which are effectively just additional taxes you pay to receive Medicare. Getting money into Roth accounts now and letting the long-term compounding occur in your Roth as opposed to your Traditional account, will go a long way towards reducing how much taxable income you’ll end up reporting in retirement.

8. Roth accounts are now far superior to Traditional accounts when passing these accounts to your heirs – The SECURE Act 2.0 effectively made Roth retirement accounts the ultimate solution when it comes to passing down wealth to your heirs in the most tax-efficient manner. If you leave a Traditional 401k account to your adult children at death, those children are will have to empty the entire account within a little over 10 years of your date of death and they will be forced to pay income tax on 100% of the distributed amount at their marginal tax rate in the year the money is distributed – even if they are in their peak earning years! With Roth accounts, these non-spouse beneficiaries can let those assets continue to grow 100% tax-free for that same roughly 10+ year period, at which point they would then be able to withdraw the entire account balance at a total tax-cost of $0. When it comes to the tax-efficient transfer of assets, it doesn’t get much better than that!

CONCLUDING WITH A CONUNDRUM

If you’re one of these younger high-earners, in order to be “right” about making Traditional 401k contributions such that you do actually end up paying a lower marginal tax rate in your retirement years, you would have had to divert a significant portion of those contributions (particularly from your earlier years contributing) from your Traditional account over to your tax-free Roth account instead. Otherwise, you’re likely to find yourself in a situation very similar to what I laid out in reason #6 above. In such a scenario, you will almost certainly be looking at astronomically high RMDs starting at age 75, and those RMDs, along with any other taxable income (like Social Security, pensions, or other investment income), are likely to push you up into one of the highest marginal tax brackets during those RMD years. In other words, to truly benefit from making Traditional 401k contribution as a young, high-earning, prodigious saver, you almost certainly need to pair those Traditional contributions along with tax-free Roth 401k contributions. In an ideal world, you would make those Roth contributions as early as possible so that you could let the power of compounding interest work the hardest on those early Roth dollars. This would then enable you to have more years of contributing to your Traditional 401k during the highest earning years of your career. Fortunately, we’re in the middle of an incredible tax-planning window. Are you taking advantage?

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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Robert Stromberg, and all rights are reserved. Read the full Disclaimer