We are a two-income couple in our mid-50s with over $2 million in our 401(k)s. Should we “sacrifice” the pre-tax benefit and switch to Roth contributions at work?
– Wendy
Like most tax-related questions, the answer is “it depends”. Based on your situation, it may make sense to transfer contributions to a Roth 401(k) for a number of important reasons, including tax diversity and tax-free growth. However, there may be additional factors that make sticking with a traditional 401(k) and opening a Roth IRA on the side more desirable. You’ll also want to consider the tax impact of pay now vs. pay later of your choice. There are many factors and assumptions involved in these calculations (such as future tax rates), but it’s worth trying to figure out which path will save you the most in taxes over your lifetime.
There is no one-size-fits-all answer to this, so it makes the most sense to discuss this with a financial advisor or tax advisor. They have advanced modeling tools that can help you see the various tax implications of sticking with a traditional 401(k) or switching to a Roth account. (And if you’re interested in working with a financial advisor, this tool can help you match one.)
What is a Roth 401(k)?
More employers than ever are offering Roth 401(k) plans as part of their benefits package. These hybrid accounts combine features of traditional 401(k) plans and Roth IRAs, giving you a workplace retirement option with special tax-free growth features. However, these plans have not yet fully caught on. Most of the money in employees’ retirement accounts is in traditional 401(k)s, mainly because people generally prefer the “pay less taxes now” model.
Unlike a regular 401(k), contributions to a Roth 401(k) will not reduce your current tax bill. These contributions are paid with after-tax dollars, so you pay taxes up front in exchange for a huge benefit down the road. The trade-off is tax-free growth, which means that if you follow all the rules, you won’t have to pay taxes on the earnings in the account when you withdraw them.
Moving all or part of your contributions to a Roth 401(k) gives you more tax diversity. If you opt for a hybrid approach, part of your money is taxable when you withdraw it (Traditional), another part is tax-free (Roth). That gives you more flexibility in future tax planning, another important benefit. (A financial advisor can help you determine if a Roth 401(k) is right for you.)
Pros and Cons of a Roth 401(k)
Roth 401(k)s have pros and cons just like any other type of retirement account. For most people, the benefits outweigh the drawbacks. But the main downside — a bigger tax bill today — could outweigh those benefits.
First, let’s look at the benefits of Roth 401(k) plans:
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Tax-free profit growth (in most cases)
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No Required Minimum Distributions (RMDs) from Roth 401(k)s for people turning 73 after December 31, 2023, thanks to the SECURE 2.0 Act
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No income restrictions to contribute to a Roth 401(k)
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Tax-free distributions on the money you correctly withdraw from your Roth 401(k).
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Lower adjusted gross income (AGI) in the future, making you more eligible for things like tax-free Social Security benefits
Now for the cons:
Here’s a tricky feature that could go both ways: Matching contributions for Roth 401(k)s have historically been made on a pre-tax basis. In that case, you don’t pay current income tax on the match, but you should pay tax on that money and any earnings if you withdraw it in the future. SECURE 2.0 Act, however, gives employers a new option to deposit those matching contributions into the Roth 401(k) account, simplifying finances for their employees. Check with your employer to see how they handle Roth 401(k) agreements. (And if you need help planning for your retirement, this tool can help match you with a financial advisor.)
Roth 401(k) vs traditional 401(k)
Now that you understand the pros and cons of Roth 401(k)s, let’s see how they compare to traditional 401(k) accounts.
The main difference between the two is the timing of the load. With a traditional 401(k) plan, you contribute pre-tax dollars, so the money you put in now doesn’t count as taxable income. You pay income tax when you withdraw the money. With a Roth 401(k), you contribute after-tax dollars, and the money you put in counts as current taxable income. When you withdraw those contributions and the associated income, they are not included in your income and you do not pay taxes on them (provided the money is withdrawn correctly).
Early withdrawals are also treated differently. With a traditional 401(k), distributions made before age 59 ½ can result in 10% early withdrawal penalties on the full amount. With a Roth 401(k), withdrawals are prorated, including contributions and income, and that 10% penalty is only applied to the income portion.
Another key difference: RMDs. Both types now require RMDs, but that will change. You must take RMDs from traditional 401(k) accounts once you reach age 73. But starting in 2024, people who turn 73 after December 31, 2023 will not have to take RMDs from Roth 401(k)s. (And if you need help planning RMDs, consider working with a financial advisor.)
Roth 401(k) vs. Roth IRA
While they share some important similarities, Roth IRAs and Roth 401(k)s have some equally important differences.
Roth IRAs have strict income limits, which prevent many people from contributing. Before 2023, individuals earning more than $153,000 or couples earning more than $228,000 cannot contribute to Roth IRAs. Anyone can contribute to a Roth 401(k), regardless of income.
Roth IRAs also have significantly lower contribution limits. The maximum contribution for 2023 is just $6,500 or $7,500 if you are 50 or older. The maximum contribution for a Roth 401(k) is $22,500 or $30,000 if you are 50 or older. In addition, Roth 401(k)s have the potential for employer agreements not available to Roth IRAs. (And if you need help choosing between retirement accounts, consider talking to a financial advisor.)
Next steps
There’s a lot to consider when choosing between traditional and Roth 401(k) accounts. Talk to your financial advisor or tax advisor to make the best possible decision based on your unique financial situation.
Tips for finding a financial advisor
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If you have specific questions about your gifting and tax situation, a financial advisor can help. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool pairs you with up to three vetted financial advisors serving your area, and you can interview your advisor matches for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Consider a few advisors before choosing one. It’s important to make sure you find someone you trust to manage your money. As you consider your options, these are the questions you should ask an advisor to ensure you make the right choice.
Michele Cagan, CPA, is a SmartAsset financial planning columnist, answering reader questions on personal finance and tax topics. Do you have a question you would like to see answered? Send an email to [email protected] and your question may be answered in a future column.
Please note that Michele is not a participant in the SmartAdvisor Match platform and she has been compensated for this article.
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