Ask an Advisor: We’re in our mid-50s and have $2 million on our 401(k). Should we focus on Roth’s contributions?

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Ask an Advisor: We're in our mid-50s and have $2 million on our 401(k).  Should we focus on Roth's contributions?

We are a working couple in our mid 50’s with over $2 million in 401(k)s. Should we “sacrifice” pre-tax earnings and switch to workplace loss contributions?

– Wendy

As with most tax-related questions, the answer is “it depends”. Depending on your situation, it may make sense to switch your contributions to Roth 401(k) for several important reasons, such as tax diversity and tax-free growth. However, there may be additional factors that make using a traditional 401(k) and opening a Roth IRA on your side more desirable. You should also consider the tax implications of choosing to pay now or pay later. These calculations involve many factors and assumptions (such as future tax rates), but it’s worth considering which method will save you the most taxes over your lifetime.

There is no simple, one-size-fits-all answer to this. As such, it makes the most sense to discuss this with your financial advisor or tax professional. We have advanced modeling programs to help you see the various tax implications of staying with a traditional 401(k) versus switching to a Roth account. (If you’re interested in working with a financial advisor, this tool can help match you with one.)

What is a Roth 401(k)?

More employers than ever are offering Roth 401(k) plans as part of their benefit packages. These hybrid accounts combine the features of traditional 401(k) plans and Roth IRAs, offering a workplace retirement option with special tax-free growth features. However, these plans are not yet fully penetrated. Most employee retirement account funds are kept in traditional 401(k)s, mostly because people generally prefer the “pay less taxes now” model.

Unlike a regular 401(k), donating to a Roth 401(k) does not reduce your current taxes. These contributions are after-tax amounts, so you’re paying taxes up front instead of receiving greater benefits down the road. The trade-off is tax-free growth. This means that if you follow all the rules, you won’t have to pay taxes on the earnings in your account when you withdraw.

Moving all or part of your donation to Roth 401(k) gives you greater tax diversity. If you choose the hybrid approach, some funds will be taxable (traditional) and some will be tax-free (Roth) upon withdrawal. This gives you more flexibility in your future tax planning, another important benefit. (Financial advisors can help determine if a Roth 401(k) is right for you.)

Pros and Cons of Roth 401(k)

Ask an Advisor: We're in our mid-50s and have $2 million on our 401(k).  Should we focus on Roth's contribution?

A Roth 401(k), like any other type of retirement account, has advantages and disadvantages. For most people, the advantages outweigh the disadvantages. But the most significant drawback – high tax bills today – may outweigh these benefits.

First, let’s look at the benefits of the Roth 401(k) plan.

  • Increased tax-exempt income (in most cases)
  • No minimum distribution (RMD) from Roth 401(k)s for anyone turning 73 after December 31, 2023, thanks to SECURE 2.0 law
  • No Income Limit for Roth 401(k) Donations
  • Tax-exempt distributions on properly withdrawn funds from Roth 401(k)
  • Future adjusted gross income (AGI) could be lower, increasing eligibility for benefits such as tax-free Social Security benefits

The drawbacks are described below.

  • No current tax cut
  • A higher current AGI can affect eligibility for things like the child tax credit

There is one tricky feature that can go either way. Matching contributions to Roth 401(k) have historically been made on a pre-tax basis. In that case, there is no current income tax on the match, but you will be taxed on the money and earnings when you withdraw in the future. However, the SECURE 2.0 Act offers employers new options to deposit these matching contributions into Roth 401(k) accounts, simplifying employee finances. Check with your employer on how they process Roth 401(k) matches. (Also, if you need help planning your retirement, you can use this tool to match you with your financial advisor.)

Roth 401(k) vs Legacy 401(k)

Ask an Advisor: We're in our mid-50s and have $2 million on our 401(k).  Should we focus on Roth's contributions?

Now that you know the pros and cons of Roth 401(k), let’s see how it compares to traditional 401(k) accounts.

The main difference between the two is the timing of the taxation. With a traditional 401(k) plan, you donate pre-tax dollars, so the amount you put in doesn’t count as taxable income. When you withdraw money, you will be taxed. With a Roth 401(k), you donate after-tax dollars and the money you put in counts as your current taxable income. When you withdraw these contributions and their associated earnings, they will not be included in your income and (if the money is properly withdrawn) you will not pay taxes.

Early withdrawals are also treated differently. Under a traditional 401(k), if he receives a distribution before age 59½, he may be subject to an early withdrawal penalty of 10% on the full amount. With Roth 401(k), withdrawals are prorated including contributions and earnings, and his 10% penalty applies only to the earnings portion.

Another important difference is RMD. Both types currently require him to have an RMD, but that will change soon. Once she reaches 73, she should get her RMD from a traditional 401(k) account. However, starting in 2024, anyone who turns 73 after December 31, 2023 will no longer be required to obtain her RMD from a Roth 401(k). (If you need help planning your RMD, consider working with your financial advisor.)

Roth 401(k) vs. Roth IRA

There are some important similarities between the Roth IRA and the Roth 401(k), but there are also some important differences.

The Roth IRA has strict income limits that prevent many people from donating. In 2023, individuals earning more than $153,000 or couples earning more than $228,000 will no longer be able to contribute to the Roth IRA. Anyone can contribute to Roth 401(k) regardless of income.

The contribution limits for Roth IRAs are also significantly lower. The maximum contribution for 2023 is just $6,500, or $7,500 if he’s over 50. The maximum Roth 401(k) contribution is $22,500, or $30,000 if you are 50 or older. Additionally, the Roth 401(k) offers employer matching possibilities not available through the Roth IRA. (Consider working with a financial advisor if you need help choosing a retirement account.)

next step

There are many things to consider when choosing between a traditional account and a Roth 401(k) account. Please consult a financial advisor or tax professional to make the best decision based on your financial situation.

Tips for Finding a Financial Advisor

  • If you have questions specific to your gifting or tax situation, your financial advisor can help. Finding a financial advisor is not difficult. SmartAsset’s free tool will match you with up to 3 vetted financial her advisors serving your area and meet with advisors for free to determine which advisor is right for you can do. If you’re ready to find an advisor to help you reach your financial goals, start now.
  • Consider several advisors before committing to one. Finding someone you trust to manage your money is important. As you consider your options, here are some questions to ask your advisor to help you make the right choice:

Michelle Kagan, CPAis a SmartAsset Financial Planning columnist answering readers’ questions about personal finances and taxes. Have a question you want answered? Send an email to AskAnAdvisor@smartasset.com. Your question may be answered in a future column.

Michele is not a participant in the SmartAdvisor Match platform and has received compensation for this article.

Photo credits: ©iStock.com/courtneyk, ©payment.com/designer491

Post Ask an Advisor: We’re in our mid-50s and have $2 million on our 401(k). Should we focus on Roth’s contribution? First appeared on his SmartAsset blog.

The views and opinions expressed herein are those of the authors and do not necessarily reflect those of Nasdaq, Inc.



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