It can be overwhelming to consider all the retirement accounts available. It’s easy to assume that you are set once you have opened a particular type of account, such as a traditional 401k. With more employers offering Roth 401(k), it’s wise to step back and look at the potential benefits.
You’ll often hear that a Roth account, whether an IRA or a 401(k), maybe a good option for young investors. This is because they are typically in a lower income tax bracket and the upfront tax deduction from a traditional retirement account may be less beneficial than the tax-free withdrawals of a Roth later on.
Financial advisers are pointing older clients to Roth accounts lately. Roth 401(k) has no income limit, unlike a Roth IRA. This allows older employees with higher earnings to enjoy tax-free withdrawals.
How do you make a decision? Let’s begin with the basics.
It Is a Matter of When You Pay Taxes
The main difference between a Roth and a traditional 401(k), is how you pay taxes. A traditional 401(k) allows you to make contributions using pretax dollars. This gives you a tax break up front, which helps lower your income tax bill. Both your earnings and contributions grow tax-deferred until you decide to withdraw them. Withdrawals are then considered ordinary income, and Uncle Sam will be liable at the current tax rate. There may also be state taxes. You’ll also be subject to a 10% penalty if your age is under 59 1/2.
It’s the opposite with a Roth401(k). Your contributions are made with after-tax dollars. There is no upfront tax deduction. Withdrawals of earnings and contributions are exempt from tax at age 59 1/2, provided you have the account for at least five years.
It all boils down to when you think it is better to pay taxes now or later. This will depend on your timeframe and what the future might look like.
It Is Better To Weigh Now Than Later
Although a tax deduction may seem appealing now, you need to plan ahead. Today’s tax rules allow for a 20% to 30% reduction in the amount of money you take out of a traditional 401k. Depending on your tax bracket, you may have to save more for retirement. This means you will need to save more money to pay for your retirement cash flow.
The Roth 401(k), if you are young and confident you will be making more in the future and be in a higher tax bracket, maybe a good option. Even if you are in your 40s, 50s, or 60s, the Roth option is worth considering.
Why? That could increase your tax bill–including potential taxes on Social Security benefits–and may reduce your disposable income. Higher taxable income could also increase the costs of your Medicare B premiums in retirement. It may be worth giving up tax deductions now to have tax-free withdrawals in the future.
You Can Hedge Your Bets By Using Both
There are two options when it comes down to traditional vs. Roth 401(k). The good news is that you don’t have to choose one or the other. You might be able to have both and choose where to make your contributions year by year.
You may be allowed to split your contributions between both accounts if your employer has a plan. You can contribute up to $19,000. to a 401(k) in 2020. You can also add $6,500 to your 401(k) if you are 50 years old or older. You could, for instance, decide to invest $9,750 into your Roth and your traditional 401K in 2020.
A Few More Thoughts
Unless you are still employed by the employer, a Roth 401k is just like a traditional 401k. Individuals who are not yet 70 1/2 years old or older can now take an initial RMD at 72.
It’s possible to eliminate that requirement by rolling over your Roth 401(k) into a Roth IRA. Before you make this decision, consider other factors like fees, legal protection, and loan provisions.
If you’re thinking even farther ahead to estate planning, inheriting money in a Roth could be good news for your heirs because provided the Roth 401(k) is at least 5 years old, they wouldn’t have to pay income taxes on the distributions from an inherited Roth.
It’s wonderful that you have options. The best option may be to choose to invest in both types. You are already saving and planning for retirement, regardless of what you choose. That’s the best decision.
This post was written by All Seasons Wealth. At All Seasons Wealth, we provide expert advice and emphasize the importance of creating in-house portfolios to personalize your strategy for asset management, financial planning, and cash management. We utilize research and perform market analysis to provide you with the top financial advisors in Tampa. No matter your needs, we can work with you to develop a consulting solution tailored to you.
Any opinions are those of All Seasons Wealth and not necessarily those of RJFS or Raymond James. Investing involves risk and you may incur a profit or loss regardless of the strategy selected. Investing involves risk and you may incur a profit or loss regardless of the strategy selected. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment. Past performance may not be indicative of future results.