Monday , 11 December 2023

Should You Contribute To A Traditional 401k, A Roth 401k – Or Both?

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A common question investors ask is whether they should contribute to their traditional 401k, Roth 401k or both? In order to make an informed decision as to which account is most [desirable you]…must first know certain characteristics of each account and this article does just that.]

The main differentiator is whether you need or want the tax benefits now or later in retirement.

  • A traditional 401k contribution is made with pre-tax dollars and you then pay ordinary income taxes on the withdrawal in retirement…[and] this…deduction from your paycheck…allows you to reduce your taxable income for the current year.
    • Two important concepts to realize are that:
      • employee matching contributions are made pre-tax…
      • [and] because the contributions are pre-tax and grow tax deferred, the IRS would like their money back at some point so they created what is called the Required Minimum Distribution (RMD).
        • The RMD amount is determined by the account’s balance the previous year times a percentage that is calculated from life expectancy tables. The percentage for a 72-year-old (as long as you turned 70 1/2 after January 1, 2020) comes out to just under 4%
        • and, in the case of non-spousal beneficiaries, the whole amount must be distributed within 10 years of the IRA owner’s passing.
    • The goal of the traditional 401k is to reduce income taxes and participate in tax deferred growth. Employees should consider this
      • if, by not including that income [it] helps you stay below a certain bracket,
      • or if you believe your individual taxes will be significantly lower in retirement.
    • The key for traditional 401k contributions is that the tax savings received from contributing to the account…should be invested into a taxable brokerage account each year.
    • An investor needs to be careful having only a traditional account in retirement [however] as any excessive withdrawals could cause them to move up a tax bracket thus increasing federal social security taxation, as well as Medicare Part B premiums.
  • The Roth 401k, on the other hand, is contributed with after-tax dollars and earnings are tax-free as long as the account has been held for more than 5 years and the investor has reached age 59 ½.
    • The Roth 401k is also subject to RMDs (although not taxed) but that can be avoided if rolled over into a Roth IRA in retirement.
    • If you prefer the Roth 401k, you:
      • are most likely a younger investor
      • and in one of the lower tax brackets and, as such, prefer to pay the taxes now during your working years because you believe you will be in a higher bracket in retirement.
    • Also, if you do not require the income in retirement or would like the remaining balance after your death to be passed to your heir, this will be tax free.
  • Roth IRAs are individual retirement accounts opened outside of your employer plans. They are contributed with after-tax dollars as well, but they differ slightly from Roth 401k in that:
    • their contribution limits are lower at $6,000 ($7,000 if age 50 or older), do not require RMDs [and]
    • the entire amount of the account can be passed down to beneficiaries tax-free as well…[but]
      • if you are single and make over $139,000 (or if married and make over $206,000) then Roth IRA contributions are not allowed.

There is a way to sidestep the income limits with Roth IRAs and that is through what’s called the “Back Door Roth.” This is where a client could contribute to a Traditional IRA and then rollover the funds into the Roth IRA account where the rollover amount would then be included as taxable income.

…At this point you might be wondering why would you choose the traditional 401k or the Roth 401k over the other?

  • The decision boils down to a) an employee’s current income status as well as b) where you believe the tax code will be in retirement.
    • The current highest tax bracket is 37%, but in 1981 it was 70% and back in 1963 it was even as high as 91%. While I hope we don’t move that drastically, the fact of the matter is we are in historically low brackets and with our deficit, especially after COVID, taxation policies will most likely increase in the future.

Advantage Of Having Both Traditional 401k and Roth 401k Accounts

If you are unsure of tax brackets and what the tax code may look like, you can also contribute to both traditional 401k and Roth 401k accounts.

  • The maximum allowed combined between the two is $19,500
  • and if you are over 50, you can catch-up with contributions each year at an additional $6,500.

Having both tax free and taxable income in retirement allows you to manage your tax bracket and allows for effective retirement income planning.