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There are many ways to minimize your tax burden when planning for retirement. Of course, making the most of tax-advantaged accounts is a central aspect of any retirement strategy.
Some employer-sponsored plans, such as 401(k)s, allow you to make contributions on either a pre-tax or Roth basis. Unlike contributions to traditional 401(k) accounts, contributions to a Roth 401(k) account are made with after-tax dollars.
This means that the money you paid in has already been taxed and therefore there is no immediate tax deduction. The advantage is that qualified withdrawals from a Roth 401(k), including contributions and earnings, are completely tax-free in retirement if you meet certain criteria.
Let’s cover the basics.
As with traditional 401(k) accounts, you can contribute up to $22,500 to a Roth 401(k) in 2023 if you’re under age 50, and up to $30,000 with catch-up contributions if You are over 50 years old.
Roth 401(k) contributions are not subject to income restrictions that currently apply to Roth Individual Retirement Accounts (IRAs). For people nearing retirement, this can be a really attractive strategy for making the most of their retirement savings.
Pre-retirees may experience a few years of reduced income between retirement and when required minimum distributions take effect at age 72, especially if you reduce your work hours or work part-time.
During these periods, it makes sense to make Roth contributions or convert funds from pre-tax to Roth while in a lower tax bracket. A Roth 401(k) allows a much higher contribution limit to achieve this than a Roth IRA.
Now let’s examine the pros and cons of including a Roth 401(k) in your retirement plan:
- Tax-free retirement benefits: The biggest advantage of a Roth 401(k) is that withdrawals in retirement are completely tax-free. This means you can potentially let your investments grow tax-free for as long as you want, giving you more flexibility in managing your retirement income. Having a source of tax-free income may help you reduce your overall tax bill in retirement, especially if you expect to live in a higher tax bracket. This can be crucial when it comes to managing your cash flow in retirement.
- Diversification of tax liability: Both the traditional 401(k) and Roth 401(k) accounts diversify your tax liability. This can be particularly valuable in uncertain tax environments. When you retire, you can strategically choose which account you want to withdraw from based on your current tax situation. For example, withdrawals from a Roth 401(k) would not increase your modified adjusted gross income, which would maintain eligibility for programs like the Premium Tax Credit if you retire before meeting the age criteria for Medicare.
- Flexibility in contributions: Roth 401(k) accounts allow for more flexibility in contributions. You can contribute to a traditional account and a Roth 401(k) account at the same time, as long as you stay within IRS contribution limits. And unlike Roth IRAs, contributions to a Roth 401(k) are not subject to income restrictions, 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, meaning you don’t get an immediate tax deduction. If you are in a higher tax bracket now and expect to end up in a lower tax bracket in 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, retirement goals, and investment strategy. To fully maximize your Roth 401(k), you must have a five-tax-year participation period to avoid nonqualified distributions, and you must wait at least until age 59½ to begin making these distributions. Unlike If you own a Roth IRA, a key limitation is that you cannot make tax-free withdrawals from your account at any time without meeting these two conditions or criteria related to death or disability. Again, the same limitations that apply to pre-tax contributions apply, which can result in your money being “locked up” after taxes and complicating your financial situation.
- Uncertainty in tax policy: The tax benefits of a Roth 401(k) depend on the tax laws remaining unchanged. Tax policies can fluctuate over time, which could affect the future benefits of your Roth account. Although tax-free withdrawals are a compelling feature, there is no guarantee that they will last indefinitely. We saw this in the legislative discussions about eliminating the Roth backdoor IRA loophole in 2021.
Ultimately, the decision may depend on your current and likely future tax situation. Many financial advisors recommend a balanced approach that combines both traditional and Roth 401(k) accounts to maximize flexibility in retirement income planning.
To make an informed decision, consult a financial professional who can assess your specific circumstances and help you develop a retirement strategy that meets your financial goals and minimizes your tax liability. Remember that there is no one-size-fits-all answer when it comes to retirement planning and your choices should reflect your individual financial needs and goals.
— By Jude Boudreaux, certified financial planner, partner and senior financial planner at The Planning Center in New Orleans. He is also a member of the CNBC FA Council.