March 15, 2021
Workplace retirement plans like 401(k)s are among the most popular retirement savings vehicles, and for good reason. Regular payroll contributions catalyze your savings each paycheck, and an employer match can add extra depth to your plan. Some plans even allow participation in two types of 401(k)s:
- Traditional 401(k)
- Roth 401(k)
While traditional 401(k)s take most of the spotlight, there are several benefits to starting or increasing contributions to a Roth 401(k) as well.
A Roth 401(k) allows you to save on an after-tax basis and can be an effective tax-planning tool both before and during retirement.
What is a Roth 401(k)?
A Roth 401(k) is an employer-sponsored retirement plan that combines the higher savings limits of a 401(k) with the tax benefits of a Roth IRA. A significant feature is that a Roth 401(k) doesn’t impose an income limit like a Roth IRA, allowing any income level to make a direct contribution.
Your contributions are after-tax, so you can’t deduct them from your current income, but qualified distributions aren’t taxed in retirement. This is effectively the opposite tax treatment of a traditional 401(k).
So, which one should you choose? The answer depends on your tax bracket, both now and in the future. With retirement income planning, your goal is to pay taxes in the lowest bracket possible. Generally, you should consider saving in a Roth while in the 24% bracket or lower, and in a traditional when you exceed the 24% bracket.
Roth 401(k) vs Roth IRA
While the basic tax treatment is the same for a Roth 401(k) and a Roth IRA, there are some key differences to understand. While they may seem subtle and easy to overlook, they can significantly affect your retirement income plan.
One of the major differences between the two is that Roth 401(k)s are still subject to RMDs. Roth IRAs are not. If RMDs will disrupt your withdrawal plan, you can roll your Roth 401(k) into a Roth IRA when you retire.
Watch out for the five-year rule here. Your Roth IRA must have been open for at least five years to withdraw the earnings tax-free.
The accounts also differ in contribution limits. A Roth 401(k) lets you contribute $19,500 plus $6,500 in catch-up contributions if over 50, whereas a Roth IRA is limited to $6,000 with a $1,000 catch-up.
Roth 401(k)s don’t have income limits on contributions like with Roth IRAs. For 2021, those limits are $125,000 for single filers and $198,000 for married filing jointly. Far too often, high-income earners discount all Roth accounts, believing they can’t contribute due to their income and miss out on these wealth-building and tax-efficient opportunities.
Consider your current and future tax bracket
The main benefit of a Roth account is paying taxes now to avoid taxes in retirement. This makes the most sense if you are in a lower tax bracket now than you anticipate you will be when you retire.
While you will owe more in taxes up-front, the long-term benefits can heavily outweigh the short-term discomfort. If used proactively, a Roth 401(k) can significantly reduce your total taxes over your working years and retirement.
Think of it like this—most people’s careers progress with time. In that case, you might initially invest in a Roth 401(k) then switch to a traditional when your income pushes you into a higher tax bracket.
Funding your Roth accounts also provides immense flexibility and freedom in retirement income and cash flow planning. You can save money on taxes, prolong your nest egg, and have more flexibility in your retirement spending.
Having a tax-free source of income in retirement can also reduce other expenses like the taxes you pay on Social Security, Medicare surcharges, or even net investment income tax.
Maximize your retirement savings by contributing to both a Traditional and Roth 401(k)
When it comes to your 401(k)—traditional and Roth—you don’t have to choose one. If your employer offers both, consider splitting your contributions to each account. You might want to fund your Roth 401(k) more early in your career, given your income and tax bracket, and balance out your contributions as your needs change.
You can also strategically contribute to each account to manage your tax bracket. Let’s look at an example.
Let’s say you made $165,000 in 2020—barely crossing the 24% threshold into the 32% tax bracket— and want to max out your annual 401(k) contributions ($19,500 in 2020). You can use your contribution strategy to your advantage, strategically employing both a traditional and Roth 401(k) to stay in the 24% bracket. What can you do?
- Contribute $17,800 to your Roth
- Make remaining $1,700 to the traditional account
This strategy reduces your income to the $163,300 limit—the top of the 24% bracket.
Keep in mind that this is just one example illustrating the use of both accounts to maximize your tax benefits.
Is a Roth 401(k) right for you?
A Roth 401(k) can be a good retirement planning tool and potentially save you a lot of money in taxes over the years. However, to get the most out of it, you have to know how to use it and when to adapt as your needs change.
Give us a call and we will help you figure out how best to incorporate a Roth 401(k) into your retirement strategy.