Most people know that diversification is important when it comes to retirement savings. Having the right mix of stocks, bonds, and mutual funds improves your chances of long-term success, but what about tax diversification?
There is another option and it’s one that more and more employers are offering: a Roth 401(k). This savings plan has some features of a Roth IRA, some of a traditional 401(k), and several benefits all its own.
What Is a Roth 401(k)?
Contributions to a Roth 401(k) are similar to those made to a Roth IRA. Since they’re after-tax, it won’t lower your taxable income today but withdrawals made at retirement age will be completely tax-free.
You might be wondering why you should bother with a Roth 401(k) if you already have a Roth IRA. Here’s the big difference: you can save a lot more with a Roth 401(k) than you can with a Roth IRA. For the 2019 tax year, the cap on Roth IRA contributions is $6,000 or $7,000 if you’re age 50 or older. On the other hand, between your traditional 401(k) and a Roth 401(k) combined, you can save up to $19,000 a year or up to $25,000 a year if you’re age 50 or older.
Another difference is Roth IRAs have an income cap of $203,000. That means if you earn more than $203,000 in any given tax year, you cannot contribute to an Roth IRA that year so you lose out on the tax-free retirements savings for that year. Roth 401(k)s don’t have an income cap at all.
There are benefits to a Roth 401(k) when you reach retirement age, too. Traditional 401(k)s have required minimum distributions (RMDs) that kick in when you turn 70 ½. Not taking your RMDs can result in a huge penalty so it’s something you really have to pay attention to. The good news? You don’t have to worry about RMDs with a Roth 401(k). You can make withdrawals when you need them without worrying about any stiff penalities. This makes a Roth 401(k) a useful planning tool, especially when it comes to your estate.
Is There a Downside?
The biggest downside to a Roth 401(k) is how it impacts your taxes today. Since this money has already been taxed, you’re essentially taking money out of your monthly spending budget and it’s not as if you can quickly withdraw it if you need it like a traditional savings account.
Let’s look at an example. If you make $75,000 a year and contribute 20% of your income or $15,000 to a 401(k), your taxable income for the year is $60,000. If you contribute that same amount to a Roth 401(k) instead, your taxable income is still $75,000. That means you’re paying more in taxes and you have access to less of your money throughout the year.
It’s important to think ahead, though. Roth 401(k) distributions aren’t taxable after retirement age if the five-year rule is met. This can be a comforting thought when you’ve retired and are living on a fixed income because you can take what you need without worrying about paying taxes.
Mix it Up
It’s important to take advantage of whatever retirement plan your employer offers. First of all, it comes right out of your paycheck so you don’t even have to think about it. Secondly, most employers offer a pretty decent match so you’re truly making the most of your money. That said, keep in mind that if your company offers both a traditional 401(k) and a Roth 401(k), company matches go to the traditional 401(k) since those funds are considered pre-tax.
Splitting your investments between both plans is a good way to take advantage of the best that both have to offer. In fact, a 50/50 split spreads your tax liability nicely so you’ll pay some now and some later.
A lot of people are hesitant to contribute to a Roth 401(k) instead of a traditional 401(k) because they’re afraid of losing the tax benefits, which is understandable. If you’re in a place where it’s essential you have more cash in hand, it might be hard to put some of your after-tax earnings into your retirement savings.
The best way to look at it is to consider whether cash flow is more important today than it will be when you retire. Tax rates in the future aren’t predictable so you may end up paying more in taxes later than you would today. With a Roth 401(k), you never have to worry about taxes in the future. All of the money in a Roth 401(k) is yours.
As you can see, it’s important to consider tax diversification with your retirement savings just as you take investment diversification into account. If you have both types of investments, you have more options later and fewer tax implications today.
Any opinions are those of Thomas Fleishel and not necessarily those of Raymond James. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. Investing always involves risk and you may incur a profit or loss. Ð'dRoth 401(k) plans are long-term retirement savings vehicles. Contributions to a Roth 401(k) are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Unlike Roth IRAs, Roth 401(k) participants are subject to required minimum distributions at age 70.5.Ðaymond James financial advisors do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.