Investing for the Long Run, BusinessWest, October 17, 2022
Barbara Trombley, CPA, MBA
Many employees are faced with the decision about whether to invest a portion of their paycheck in a Roth 401k or traditional 401k. What is the difference and what are the implications? First, most plans now offer both options. If your plan does not, it may be as simple as asking the plan provider if both options can be offered. One major difference between the two is how they are taxed. The traditional 401k gives tax benefits now. The employee can deduct their contributions from their taxes now – up to $20,500 if you are under age 50 and up to $27,000 if over. This can save thousands on your tax bill, depending upon what bracket you are in.
The Roth 401k does not offer tax benefits now. Contributions are made with after-tax money. Any growth on the funds is never taxed as long as the account has been held for at least five years , the distribution is qualified, and you take the distribution(s) after age 59 ½. The investment choices are usually the same as the traditional 401k and many people contribute to both.
What option is best for you? Usually, it comes down to your personal tax situation. If you are in a very high tax bracket now and expect to be in a lower bracket at retirement, it may make sense to get the tax benefits now. For example, if you are single and have taxable income over $215,951, incremental income is taxed at 35%. Your contributions to a traditional 401k plan could save you $350 on every $1000 contribution. The flipside of this strategy is that, in retirement, all withdrawals are taxed as ordinary income.
Additionally, investors in traditional retirement plans need to take required minimum distributions beginning at age 72. Even if the retiree does not “need” the funds, the government is ready to begin collecting its taxes on the funds that were deferred in the plan. As the retiree ages, the RMD factors increase, usually resulting in larger distributions. A young employee now that continually contributes to a traditional retirement plan, may have a large balance later in life. When it is time to take RMD’s if the account hasn’t been tapped previously, the amount to withdraw may be rather large, resulting in a big tax bill.
A Roth 401k is subject to the same RMD requirement as the traditional 401k. If the Roth 401k is rolled over into a Roth IRA, then RMD’s are not required to be taken. The funds can be used or held at the individual’s discretion, giving more flexibility to tax planning.
Both plans can be left directly to beneficiaries, and, in most instances, the beneficiary will have ten years to liquidate the account. Of course, leaving tax-free money to your heirs would be more desirable to them but planning should be done to see if it is the correct choice for you.
In our opinion, it is desirable for retirees to have both types of funds – pre-tax and post-tax. This could give them a lot of flexibility to properly tax plan in retirement. Consult with your financial and tax advisors to see what makes the most sense for your individual situation.
Securities offered through LPL Financial. Member FINRA/SIPC. Advisory services offered through Trombley Associates, a registered investment advisor and separate entity from LPL Financial.
Trombley Associates and LPL Financial do offer tax advice or services. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.