Five questions to ask yourself before upgrading to a Roth 401 (k)
If you have a 401 (k) at work, you are probably familiar with the standard advice regarding such plans: make sure you contribute enough to receive any employer, and make the maximum contribution if you are able. But some employers offer both a traditional 401 (k) and a Roth 401 (k), and it can be difficult to determine if it makes sense to change. It’s worth understanding how both types of retirement accounts work and asking yourself five questions to decide which one is best for you.
Traditional vs Roth 401 (k) s
No matter what type of 401 (k) account you use, you always have the same contribution limit: in 2021, you can save up to $ 19,500 in total, plus an additional $ 6,500 if you are over 50. years. When you reach retirement, both types of 401 (k) have required minimum distributions (RMD) for account holders over 72 years of age. This is a significant difference from a Roth IRA, which has no distribution requirement. The owner of a Roth 401 (k) could eliminate his distribution requirement by transferring it to a Roth IRA, although he would like to compare the details of the two accounts before doing so.
The main difference between a traditional Roth 401 (k) and a Roth 401 (k) is when taxes are paid. If you contribute to a traditional 401 (k), you put pre-tax dollars into the account. In other words, contributing to a traditional 401 (k) will give you tax relief that year because your contribution will help reduce your taxable income. When you withdraw money from the account at retirement, you will pay regular income taxes on those withdrawals.
The Roth 401 (k) basically works the other way around: contributions are made with after-tax dollars, which offers no tax benefit in the year the contribution is made, but withdrawals are tax-free as long as you have over 59 and a half years and have held the account for at least five years.
The decision between a traditional account or a 401 (k) account is often presented as purely a decision about when to pay taxes, and taxes should certainly be a determining factor in choosing the type of account. However, there are many tax issues to consider, so below are a few questions to ask yourself to help you decide if switching to a Roth 401 (k) makes sense for you:
Do you expect to have a higher or lower income in retirement than today? In general, you want to plan your contributions and your retirement savings withdrawals so that you pay your taxes in the lowest possible bracket. If you are currently earning less than what you expect to earn in retirement, it often makes sense to pay your taxes now and contribute to a Roth 401 (k), instead of paying taxes later in life when your income is low. higher. That’s why you’ll often see Roth 401 (k) and Roth IRAs recommended for young savers, especially those with lower current incomes. On the other hand, if you are earning a high income now, you could save money by reducing your taxable income today via a traditional 401 (k) contribution and then paying taxes on your withdrawals in retirement then. that you would be in a lower tax bracket. .
Can you spend more of your salary in 401 (k) savings than you currently do? If you are making traditional 401 (k) contributions now, switching to a Roth 401 (k) will cost you more, as it will also increase your tax bill. Making the maximum contribution to a traditional 401 (k) would require $ 19,500 of your paycheck, but maxing out a Roth 401 (k) would require $ 19,500 plus an increase in your tax bill. If you don’t have the budget flexibility to upgrade to a Roth 401 (k) while still maintaining the same level of savings, you’re probably better off staying in a traditional 401 (k).
Would increasing your taxable income have negative tax consequences for you and your family? Your traditional 401 (k) contribution reduces your taxable income, unlike a Roth 401 (k) contribution. It is possible that adding your Roth contributions to your taxable income will increase your income enough to push you into a higher marginal tax bracket or make you ineligible for certain other deductions you have relied on in the past. Before deciding to make the switch, you should make sure you understand all of the tax implications that this decision may have.
Do you already have assets in a Roth 401 (k) or IRA, or are all of your retirement assets in qualified accounts like traditional IRAs or 401 (k)? If your current portfolio is made up entirely or almost entirely of qualified retirement assets, it may be a good idea to contribute to a Roth 401 (k). Having a variety of account types with your retirement savings will allow you to diversify your sources of retirement income, which can be helpful from a tax perspective. Roth 401 (k) gives you access to tax-free income in retirement, and you can even eliminate RMD requirements by converting to a Roth IRA.
Additionally, a major benefit of the Roth 401 (k) for high earners is that they can make direct contributions regardless of income level, which is not true for a Roth IRA (although it is possible to make a backdoor contribution to a Roth IRA). The Roth 401 (k) is a simple way for employees of all skill levels to save in Roth assets, and the higher contribution limit for 401 (k) compared to IRA will save individuals faster.
Do you expect a period of low income in the future? Instead of diversifying your savings to get a mix of Roth and traditional assets, you can instead convert some of your traditional 401 (k) or IRA assets into Roth assets to achieve the same goal. If you convert a traditional asset to a Roth asset, you will pay ordinary income tax on the amount you convert in the year of the conversion. If you expect years of lower income in the future, perhaps after retirement but before Social Security payments start, these years can be prime opportunities to convert pre-tax retirement account assets into Roths. Strategic conversions allow you to take advantage of the initial tax advantage of a traditional 401 (k) account while giving you flexibility in timing and optimizing your tax burden. You can convert traditional assets to Roth assets at any time, not only when your income is low, but converting can be a particularly attractive alternative to saving directly into a Roth 401 (k), especially in low years. returned.
The traditional and Roth 401 (k) are powerful retirement savings vehicles and both offer significant benefits to savers. It’s important to note that you don’t necessarily have to choose between the two either: as long as your total contributions stay below $ 19,500 or $ 26,000 for those over 50, you can put money in. both accounts annually. If you’re still not sure which savings approach is right for you, a qualified financial advisor can help you assess your personal situation and recommend a strategy.
Disclosure: This article is for informational purposes only and does not constitute a recommendation of any particular strategy. Opinions are those of Adam Strauss as of the date of publication and are subject to change and Pekin Hardy Strauss Wealth Management Disclaimer.