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There are a lot of opportunities to minimize your tax burden when it comes to retirement planning. Of course, making the most of tax-advantaged accounts is a key aspect of any retirement strategy.
Some employer-sponsored plans such as 401(k)s allow you to make contributions on either a pretax or a Roth basis. Unlike contributions to traditional 401(k) accounts, those to a Roth 401(k) are made with post-tax dollars.
This means that the money you contribute has already been taxed, so there are no immediate tax deductions. The upside is that qualified withdrawals from a Roth 401(k), including both contributions and earnings, are entirely tax-free in retirement if you meet certain criteria.
Let’s cover the basics.
Like traditional 401(k) accounts, in 2023 you can contribute to a Roth 401(k) up to $22,500 if you’re under age 50, and up to $30,000 with catch-up contributions if you’re over 50.
Roth 401(k) contributions are not subject to income limitations that Roth individual retirement accounts, or IRAs, currently have. For people approaching retirement, this can be a really appealing strategy to max out their retirement savings.
Pre-retirees might experience some lower-income years between retirement and when required minimum distributions kick in at age 72, especially if you might be downshifting hours or working part-time.
It makes sense during those periods to make Roth contributions or convert funds from pretax to Roth while in a lower tax bracket. A Roth 401(k) allows a much higher contribution limit to accomplish that than a Roth IRA.
Now, let’s examine the pros and cons of incorporating a Roth 401(k) into your retirement plan:
- Tax-free withdrawals in retirement: The most significant advantage of a Roth 401(k) is that withdrawals made during retirement are entirely tax-free. This means you can allow your investments to potentially grow tax-free for as long as you wish, giving you greater flexibility in managing your retirement income. By having a tax-free source of income you can potentially reduce your overall tax burden in retirement, especially if you anticipate being in a higher tax bracket. This can be a game changer when it comes to managing your cash flow in retirement.
- Diversification of tax liability: Having both traditional 401(k) and Roth 401(k) accounts provides diversification in terms of your tax liability. This can be particularly valuable in uncertain tax environments. When you retire, you can strategically choose which account to withdraw from based on your tax situation at the time. Withdrawals from a Roth 401(k) for instance, would not increase your modified adjusted gross income, which would maintain eligibility for programs such as the Premium Tax Credit, if you retire before meeting age criteria for Medicare.
- Flexibility in contributions: Roth 401(k) accounts allow for more flexibility in contributions. You can contribute to both a traditional and a Roth 401(k) account simultaneously, as long as you stay within the IRS contribution limits. And unlike Roth IRAs, contributions to a Roth 401(k) are not subject to income limitations, allowing you to better structure your tax liabilities and control your taxable retirement income.
- No immediate tax deduction: Contributions to a Roth 401(k) are made with after-tax dollars, which means you won’t receive an immediate tax deduction. If you’re in a higher tax bracket now and expect to be in a lower one during retirement, this could be a disadvantage.
- Complex decision-making: Managing both traditional and Roth 401(k) accounts requires careful planning. Deciding how much to allocate to each account can be a complex decision that depends on your current tax situation, your retirement goals and your investment strategy. To fully maximize the Roth 401(k), you must have a five-tax-year period of participation to avoid nonqualified distributions and you must wait until at least age 59½ to begin those distributions. Unlike with a Roth IRA, a major limitation is that you cannot make tax-free withdrawals from your account at any time without meeting those two conditions, or criteria around death or disability. The same restrictions that apply to pretax contributions also apply here, which can “lock up” your after-tax dollars and complicate your financial situation.
- Uncertainty in tax policy: The tax benefits of a Roth 401(k) are contingent on tax laws remaining unchanged. Tax policy can fluctuate over time, which could affect the future benefits of your Roth account. While tax-free withdrawals are a compelling feature, they are not guaranteed to last indefinitely. We saw this with the legislative discussions around eliminating the backdoor Roth IRA loophole in 2021.
Ultimately, the decision may come down to your current and projected future tax situation. Many financial advisors recommend a balanced approach, combining both traditional and Roth 401(k) accounts to maximize flexibility in retirement income planning.
To make an informed decision, consult with a financial professional who can assess your specific circumstances and help you create a retirement strategy that aligns with your financial objectives and minimizes your tax liability. Remember that there is no one-size-fits-all answer when it comes to retirement planning, and your choice should reflect your individual financial needs and goals.
— By Jude Boudreaux, certified financial planner, partner and senior financial planner with The Planning Center in New Orleans. He is also a member of the CNBC FA Council.