By: Gary Hirsh, CPA, CFP®
As the year draws to a close, many investors wonder whether they should maximize their contributions to their tax-deferred retirement accounts. The answer, as with most financial planning questions, is that it depends on your unique circumstances.
Understanding Your Options
Before diving into strategy, it's essential to understand that all retirement plan contributions require earned income—wages, self-employment income, or ordinary partnership income from services rendered. Investment income, including interest, dividends, capital gains, and rental income, is not included.
If you're an employee, your company may offer a 401(k) or 403(b) plan. If you're self-employed, you might have access to a solo 401(k) or a Simplified Employee Pension Plan (SEP). Additionally, IRAs may be available depending on whether you or your spouse participates in an employer-sponsored plan.
These accounts typically come in two flavors: pre-tax (traditional) or after-tax (Roth). Note that employers aren't required to offer Roth 401(k) options, so check what's available through your plan.
Whether you should maximize your contributions hinges on several key considerations.
Tax Benefits vs. Cash Flow Needs
From a pure tax perspective, funding a retirement account almost always makes sense if you have any tax liability. However, life sometimes has other priorities. If you're saving for a home down payment, planning to purchase a car, paying college tuition, tackling credit card debt, or managing other pressing financial obligations, those needs may take precedence.
At a bare minimum, I recommend contributing enough to capture your full employer match—it's essentially free money. The only exception is if you're planning to leave your job soon and the company match is subject to vesting requirements that you won't satisfy.
Current vs. Future Tax Rates: The Critical Question
The most significant factor in choosing between pre-tax and Roth contributions is comparing your current tax rate to what you expect it to be in retirement. While this sounds straightforward, predicting future tax rates is challenging.
Consider what your retirement income picture might look like. Will you have part-time work? What about investment income, Social Security benefits, and required distributions from traditional retirement accounts? Are you planning to relocate to a state with lower or no income taxes?
For younger workers in lower tax brackets today, I generally recommend Roth contributions. You pay taxes at your current low rates, then enjoy tax-free growth and tax-free qualified withdrawals in retirement. Additionally, Roth accounts have no required minimum distributions, unlike traditional accounts, which mandate withdrawals starting at age 73.
For high earners, particularly those in states like California, New York, or New Jersey where the highest marginal state tax rates exceed 10%, pre-tax contributions typically make more sense. You're saving close to 50% in combined federal and state taxes today.
The Flexibility Advantage
Roth accounts offer unique flexibility. You can withdraw your contributions (not earnings) at any time without taxes or penalties, whereas early withdrawals from traditional accounts trigger a 10% penalty on top of ordinary income taxes. This flexibility extends into retirement: with both Roth and traditional accounts, you can strategically manage annual distributions to control your tax bracket.
Special Consideration: SEP IRAs for the Self-Employed
For self-employed individuals, SEP IRAs warrant special attention due to their flexibility in decision-making and high contribution limits.
Unlike traditional IRAs capped at $7,000 in 2025 ($8,000 if age 50 or older), SEP IRAs can be established and funded up until your tax return due date (including extensions) with contributions up to $70,000. The contribution is calculated as 20% of your self-employment income. Since 2023, Roth SEP IRAs have also become available.
There's one important trade-off to consider: SEP IRA contributions reduce the business income eligible for the 20% Qualified Business Income Deduction, assuming you otherwise qualify. This strategy effectively reduces the net tax benefit of your contribution, while the full amount will eventually be taxed upon distribution.
Making Your Decision
These strategies can be complex, and the right choice depends on your individual financial situation, tax circumstances, and long-term goals. I strongly encourage you to review your options with your CPA and financial advisor before year-end to ensure you're making the most advantageous decision for your circumstances.
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