Like many estate-planning decisions, whether it is best to invest in a traditional 401(k) retirement savings plan or a Roth 401(k) comes down to taxes. More specifically, does it make more sense for you to pay taxes on your withdrawals in the future or on the contributions you make today? Weighing these options requires a thorough assessment of your unique needs, goals and financial circumstances, preferably under the guidance of your financial advisors.
Both traditional and Roth 401(k) plans provide workers with a simple option to save for an eventual retirement via salary deferrals. While the annual contribution limits for both types of plans are the same, how you make those contributions and take them as distributions can vary significantly.
Contributions to traditional 401(k) plans are made with pre-tax dollars, meaning the amount you contribute is not subject to tax, but those amounts are deducted from your taxable income in the years of funding. Your savings and earnings grow tax-deferred until you reach age 59½, when withdrawals are subject to tax at your ordinary income tax rate. When you reach age 73 between 2023 and 2032, you must begin taking required minimum distributions (RMDs) each year and paying the related tax liabilities at your ordinary income tax rate.
By contrast, the money you contribute today to an employer-sponsored Roth 401(k) plan is made with after-tax dollars that can grow tax-free and be withdrawn free of taxes after you reach age 59½. Moreover, beginning in tax year 2024, RMDs no longer apply to Roth accounts.
To choose the plan that’s right for you, consider the answers to the following questions:
Do you expect your ordinary income tax rate to be higher or lower when you retire? For many people, a departure from the workforce will reduce their annual income and put them in a lower tax bracket than during their prime earning years. Under these circumstances, a traditional 401(k) is a good option since the amount of tax you will pay on withdrawals in retirement could be less than the deduction. If you do not expect any changes in your income during retirement, a Roth 401(k) may make more sense.
Would it be beneficial to reduce your taxable income this year? If you are a high-income earner and the answer is yes, consider a traditional 401(k) plan that allows you to reduce the amount of income subject to tax by the amount of your contribution.
Do you have the funds to pay taxes on the amount you contribute to your retirement plan today? If the answer is yes, you may want to consider contributing to a Roth IRA in which you will pay taxes upfront in return for tax-free withdrawals in retirement. However, remember that taxes you pay on Roth contributions will be taken from your salary, leaving you with less take-home pay.
How long until you expect to retire? The younger you are when you begin saving, the more time you have until your retirement date, and the greater benefit you can yield from a Roth 401(k). Over time, the compounding interest and potential appreciation of your savings may offset the taxes you pay on those contributions.
While these questions can provide some easy guidance on the choice between a traditional 401(k) or Roth 401(k), it is vital to engage your financial advisors to understand all the implications of your decision, including the risks and benefits based on your unique circumstances. In many instances, you could have an opportunity to convert a traditional 401(k) to a Roth 401(k) and yield the added benefit of tax-free withdrawals in retirement. Or you may be able to convert your Roth 401(K) to a Roth IRA and allow your savings to continue growing tax-free without the burden of required minimum distributions. Each scenario requires precise timing and execution to maximize tax efficiency.
About the Author: Olga Ismail is the head of Retirement Plan Consulting and a financial advisor with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with PWA Securities, LLC. She can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or info@provwealth.com.
Provenance Wealth Advisors (PWA), 200 E. Las Olas Blvd., 19th Floor, Ft. Lauderdale, FL 33301Â (954) 712-8888.
Olga Ismail is a registered representative of and offers securities through PWA Securities, LLC, Member FINRA/SIPC.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Any opinions are those of the advisors of PWA and not necessarily those of PWA Securities, LLC. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of PWAS, we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Prior to making any investment decision, please consult with your financial advisor about your individual situation.
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Posted on June 12, 2024