If you’re not earning big bucks this year, consider saving money in a Roth 401(k) instead of a traditional 401(k).
Roth contributions make sense when your current tax rate is less than your rate in retirement. That often applies to young workers who are earning entry-level salaries. But it can also be true of a middle-aged worker who has been out of work for part of the year or has switched to a lower-paid job like teaching. Or even an older executive who is working part time.
All of these people likely will come out ahead by contributing to a Roth 401(k) while they are in a low tax bracket.
In a traditional 401(k), you contribute pretax dollars and are taxed when you spend the money. It’s a good deal for workers who are in higher tax brackets now than they will be in retirement.
In a Roth 401(k), you contribute after-tax dollars but any money taken out of the account in retirement is tax-free. It’s a good deal for people who will have a higher tax rate in retirement than they do currently.
No one knows for sure what tax rates will be in the future. But given budget deficits, most experts assume they will be higher than they are today.
Kelly Wright, director of financial planning at Verdence Capital Advisors, says Roths make sense for younger workers in the 24% or under tax brackets who are in a career path where raises could quickly push them to higher brackets.
By contrast, workers who have built most of their wealth in tax-deferred accounts may have higher taxes when they start taking required minimum distributions beginning at age 72, says Jim Colavita, wealth management advisor at GenTrust Wealth Management.
“I know people in their retirement years, because of RMDs, have some of their best years ever, earnings-wise,” he says.
In the past, most employers only offered traditional 401(k)s. But many now offer both traditional and Roth 401(k)s, so workers get a choice.
A Roth account is a sort of forced savings plan. If you contribute the $22,500 maximum pretax in 2023 to a traditional 401(k), the government is effectively part owner of that $22,500 and will demand its share in taxes when you take the money out. By contrast, if you contribute $22,500 after-tax to a Roth, you will take home less money now because you’re paying more taxes, but the $22,500 is all yours.
There are two primary requirements for tax-free distributions from Roths. You must be at least 59.5 years old to withdraw profits (contributions can be withdrawn at any time) and the account must be open at least five years.
There are some situations where you can take Roth money out before age 59.5. Roth accounts can be used to fund a first home purchase, and that use is considered a qualified withdrawal, so the money isn’t subject to taxes or penalties, even on earnings.
But for most workers, the Roth account is such a great savings vehicle that they will want to leave the money in as long as possible to grow tax-free. If they or their spouses don’t spend down the Roth in their lifetimes, the money can grow tax-free for another 10 years before their heirs must take the money out.
Where a worker falls in the federal tax brackets now versus later determines whether a Roth makes sense. Wright says savers should calculate what their taxable income would be if they invested in the traditional 401(k) versus the Roth 401(k) by comparing the two tax rates.
If plan sponsors allow workers to split their contributions between a Roth and a traditional 401(k), there’s an opportunity to invest in both plans and keep their lower tax bracket, Wright says.
Wright gives an example. Suppose a worker makes $55,000 and wants to save $5,000 in a 401(k). If she subtracts the federal standard deduction for a single filer of $12,950, her taxable income is $42,050, putting her in the 22% tax bracket, just above the 12% tax bracket’s income limit of $41,775. Wright says she could put $275 into a traditional IRA, and $4,725 into a Roth to remain within the 12%.
Wright says this year he’s splitting his own 401(k) contributions between the Roth and traditional plan because he expects he will be in a lower tax bracket this year versus 2023. He took some time off this year before starting his job at Verdence, and he is in his last year of paying alimony, which was tax-deductible.
“’I’m hedging my bets. I think my income is going to go way up next year, so it won’t make sense for me to do Roth then,” he says.
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