Retirement savings across the United States is largely invested in 401(k) plan. That’s because contributions that you may make to a 401(k) bring down your taxable income today.
However, it is important to remember that when you make withdrawals from your 401(k) after retirement your distributions will be subject to income tax.
Instead of putting all your eggs in one basket, the traditional 401(k), you might consider another retirement savings option: a Roth 401(k). Employers increasingly offer this choice.
The key difference between a Roth 401(k) and a traditional 401(k) is that your contributions under a Roth 401(k) will be deducted post-tax. This enables you to have mostly tax-free income and distributions later, upon retirement.
This savings approach may be ideally suited for individuals who believe that they might have a higher income level during retirement.
To understand whether a Roth 401(k) is beneficial for you in the long run, consult with a financial planner. In this short guide, however, we will give you an overview of what tax benefits you could get with a Roth 401(k) investment.
To begin with, you should know that if you make contributions to a Roth 401(k) these will not reduce your taxable income today. However, when you will finally take the distributions your money will be completely tax-free.
This is similar to the benefits you have under Roth IRA, but a key difference is that a Roth 401k will let you contribute substantially higher amounts than a Roth IRA.
For 2019 and 2020, a Roth IRA only allows you to contribute up to $6,000. If your age is 50 or above, you can contribute an additional $1,000.
In contrast, the much more liberal 401(k) plans allow you to save up to $19,000 per year in tax year 2019. This limit also applies to Roth 401(k). If your age is 50 or above, you can contribute an additional $6,000.
A Roth IRA is subject to an income cap. If your income is more than $203,000 in 2019 you are not allowed to contribute to a Roth IRA. In other words, if you are in a higher income bracket this tax-free investing opportunity is not for you.
A Roth 401(k) does not have that limitation.
Advantages vs. drawbacks
While there is no single ideal retirement savings option for all, the benefits of Roth 401(k) outweigh the potential drawbacks for people with a higher income and those who expect to continue to be in a higher income bracket during retirement.
The obvious limitation of a Roth 401(k) is its impact on today’s tax liability. For example: If your annual income is $100,000 and you contribute $19,000 (maximum limit) to a traditional 401k, you would have a taxable income of $81,000.
However, if the same $19,000 is invested in a Roth 401(k) your taxable income would still be $100,000.
Saving into the Roth 401(k) will reduce your current spendable income, but the upside is that you are forcing yourself to save more for a more financially secure and tax-free retirement.
When you are 59½ and have complied with the 5-year rule you will have no tax burden when you take distributions from a Roth 401(k). If you need $30,000, you simply withdraw $30,000 and you have no taxes to pay.
On the other hand, if you took out a similar amount from a traditional 401(k) you would be liable to pay income tax on the entire amount.
Another key point to note is that as an owner of a Roth 401(k) you will have to take required minimum distributions (RMDs) when you reach the age of 70½. This condition does not apply to Roth IRA account holders.
Therefore, your financial planner might recommend that you roll your Roth 401(k) to a Roth IRA before you reach this age limit.
The bottom line is that both the traditional 401(k) and the Roth 401(k) allow you to save automatically, and both provide you matching funds (as long as your employer is offering them.)
A flexible approach to saving for your retirement is possible because the Roth 401k is not a all-or-nothing type of a deal. You may consider dividing your contributions half-and-half between the traditional 401(k) and Roth 401(k).
This could give you the best of both the worlds by way of enjoying the benefits of pre-tax savings while still retaining the advantages of tax-free growth.
Maximum long-term advantage
As a prudent, long-term investor, your saving strategy should not be limited by the short-term tax advantage alone that a traditional 401(k) offers. People often compare a traditional and a Roth 401(k) as a choice between paying deferred taxes versus paying them now.
In reality, it is not so simple.
To make a choice between a traditional and a Roth 401(k), you need to look at your today’s cash flows against the estimated cash flows during retirement. Contributions are not the same as income, so as a taxpayer you should free yourself from that mindset.
People often do not realize that earnings are the most significant factor to analyze when deciding between a traditional and a Roth 401k.
When you have taxable earnings, as will be the case with a traditional 401(k) in retirement, the cost could be considerably high if you focus on distributions over many years in the future, at tax rates that cannot be predicted today.
In case of Roth 401(k) the earnings will never be subject to any taxes. That makes it important to consider this: You could have substantial earnings over a few decades of your retirement and you will never have to pay any tax on them.
Tax diversification can cover your bases
You may be in a position where you have no idea what your income and tax rate will look like in retirement. This is where tax diversification comes in, where you can contribute to both a traditional 401(k) and a Roth 401(k).
With this combination you will have both tax-free and taxable options of withdrawal. Based on your tax situation you can determine in retirement when you want to tap into either account. The choice is yours.