Roth Deferral: What Is It and How Can It Benefit You in Retirement?


Are you worried about taxes in retirement? You may want to explore Roth deferral as part of your retirement-saving strategy. Roth deferral is a way to reduce your taxable income and drum up tax savings.

In this article, we will go over Roth deferral, what it is, and how to incorporate it in your tax-planning strategy. This article will also cover ways to use Roth deferral to save money on your taxes. Read on for more insights into this tax-smart money move.

With this option, you make after-tax contributions to your IRA or employer-sponsored retirement plan and then take tax-free withdrawals in retirement. This can be a great way to diversify your tax burden in retirement and maximize your income with tax-free dollars.

How Does Roth Deferral Work?

Where Roth deferral often comes into play is with a Roth 401(k) plan or other Roth employer-sponsored plan. In these sorts of workplace plans, you have the option to make either pre-tax or post-tax contributions to the plan. With pre-tax contributions, your investment and its gains will grow with tax advantage, and your distributions will be taxed as income.

In a Roth plan, your contributions are taxed as current income, but your distributions will be tax-free in the future. Many people like the benefit of Roth deferral because it can offer considerable tax savings in the future.

This can be a nice benefit for high-income earners and entrepreneurs. Since these contributions are taxed upfront, you don’t have to worry about what future tax rates might be, as those withdrawals will be tax-free.

Types of Roth Accounts

There are two basic types of Roth savings accounts. One is the Roth IRA. The amount that you can contribute to it is periodically indexed for inflation.

One advantage of having a Roth IRA is that you will never have to take mandatory minimum distributions from it. You can leave the entire balance in and pass it on to your heirs tax-free if you like.

The other type of Roth account is a Roth employer retirement plan, which is discussed below. The contribution limits for Roth employer retirement plans are the same as for traditional qualified plans.

There is also a 10% early withdrawal penalty for any distributions taken before age 59.5 unless a qualified exception applies. Early Roth withdrawals are also taxed as ordinary income. That means that instead of tax-free distributions, you will have taxable income — plus the penalty.

For this reason, Roth IRAs and qualified plans are the last place that you want to draw money from if you are under age 59.5 or haven’t had a Roth account open for at least five years.

Are Roth Deferrals the Same as Roth IRAs?

Not quite. Unlike Roth IRA contributions, there are no income limits for Roth deferrals.

This gives those who would otherwise be ineligible for Roth IRA contributions to build up a tax-advantaged source of funds over time. It’s a means by which they can diversify the tax status of their investment holdings.

Income Threshold Phaseouts

How does those income limits work for a Roth IRA? Unfortunately, if your earnings exceed a certain amount, then your Roth IRA contributions may be limited to a lesser amount than the full contribution. If your income exceeds these limits, then you won’t be allowed to contribute to a Roth IRA.

However, if you are participating in your employer-sponsored retirement savings plan such as a 401(k), 403(b), or 457(b) plan, then you can make Roth contributions regardless of your level of income. There is no income phaseout threshold for those who make Roth contributions to their retirement plans.

The only caveat is that your plan must allow you to do this. Not all employer retirement plans allow participants to make Roth contributions. However, the percentage of them that do is growing.

Who Are Roth Plans Best Suited For?

Roth plans are popular with entrepreneurs and high-income earners because they can usually afford to make after-tax contributions while they are still working.

Executives who may be privy to non-qualified retirement plans, such as deferred-compensation plans or split-dollar life insurance, are often attracted to the tax-free withdrawals that they can make from a Roth account after they retire.

For example, take a retired businessman who earned $500,000 a year while he was working. He now receives $50,000 of deferred compensation in retirement on top of his Social Security and pension.

He may find a tax-free pool of money quite handy, as any additional distributions from traditional IRAs or qualified plans could push him into a higher tax bracket. So, if our retired businessman took $50,000 out from his Roth plan to buy a boat, the distribution wouldn’t affect his tax situation.

Pros and Cons of Roth Deferral

The most obvious disadvantage of making Roth contributions is that they can only be made with after-tax money. You must pay the tax on your Roth contributions at the time you make them.

This means that there will be less money in your pocket for the time being than there would be if you were to make pre-tax contributions to another retirement account. However, the prospect of not having to worry about taxes on withdrawals can be very appealing to those who will have sizable retirement incomes.

As said before, a Roth withdrawal for a large purchase will have no impact on the rest of your finances. For example, say that our retired businessman above instead took the $50,000 out of a traditional IRA or qualified plan. He wouldn’t only have to pay tax on this money, but he also may have to pay it at a higher rate because he has landed himself in a higher tax bracket.

For this reason, sometimes financial professionals guide people to take their income streams from taxable accounts and wait to take larger amounts from Roth accounts.

Next Steps to Explore Roth Deferrals for Retirement

If you are interested in excluding some of your retirement income from taxes, it’s time to talk to a qualified financial professional. A good financial advisor will be familiar with the tax rules pertaining to Roth accounts and how they can work for you.

Also talk to your employer’s HR department to find out whether you can make Roth contributions to your retirement plan. Your employer may have already sent you the information necessary to do this, but in most cases, you can also call your HR department. They will be able to fill you in on all the Roth options that you have.

In some cases, your advisor may say that you will be better off with traditional IRAs and qualified plans. This can happen if you look to end up in one of the lower tax brackets in many cases. But if your total income is high enough to land you in a higher tax bracket, then you may want to take the Roth path if it’s available.

But this option is contingent upon whether your employer allows you to make Roth contributions to your retirement plan. Either way, if they don’t, you can also explore other sources of tax-free income, including cash value life insurance, municipal bonds, an HSA for healthcare spending, and more.  

Some Final Thoughts on Roth Accounts and Taxes in Retirement

Roth IRAs and Roth employer retirement plans can let you build up a pool of tax-free cash when you retire. If your income is too high to contribute to a Roth IRA and your employer doesn’t offer a Roth retirement savings plan, then other sources of tax-free income may be good to explore.

Consult with your financial advisor to find out which path is best for you. If you are looking for a someone to help you with your questions about retirement in general, you may want to consider an independent financial professional.

They have no ties to one financial company or any quotas to satisfy. Their business model gives them the freedom to explore multiple options for your situation.

If this sort of framework appeals to you, then check out our “Find a Financial Professional” section, where many independent financial professionals are located and can be contacted directly. You can request an initial appointment to discuss your goals, concerns, and situation. Should you need a personal referral, please call us at 877.476.9723.

Next Steps to Consider

  • Start a Conversation About Your Retirement What-Ifs

    retirement planning services next steps

    Start a Conversation About Your Retirement What-Ifs

    Already working with someone or thinking about getting help? Ask us about what is on your mind. Learn More

  • What Independent Guidance
    Does for You

    independent vs captive advice

    What Independent Guidance
    Does for You

    See how the crucial differences between independent and captive financial professionals add up. Learn More

  • Stories from Others
    Just Like You

    safe money working with us

    Stories from Others
    Just Like You

    Hear from others who had financial challenges, were looking for answers, and how we helped them find solutions. Learn More

Proud Member