When you think about the biggest purchases in your life most believe their house is the largest. Thinking about our lifetime purchases further we discover RETIREMENT is probably the most expensive thing we will ever buy.
Perhaps you’ve never thought of “buying” retirement, but that’s exactly what you do when you contribute to retirement accounts like a 401(k) plan or IRA. You are buying retirement dollars now to be used later. When you consider retirement income may need to last multiple decades it’s easy to understand why retirement is not cheap. However, by following some basic steps during your working years - save early and often, invest in stock and bond index funds, limit costs - you can make the cost of retirement more manageable.
Another step that may reduce your retirement costs even further is to contribute to a Roth 401(k) account instead of traditional 401(k). Not all 401(k) plans allow Roth contributions, but if your plan does it is worth considering the pros and cons of putting your money in the Roth. Here are the main points to consider about Roth 401(k) contributions.
How to Choose
While traditional deferrals are contributed pre-tax and then taxed when withdrawn, Roth deferrals are the opposite - contributed after-tax and then withdrawn tax-free. Taking the tax hit on Roth deferrals now may save you a lot in taxes in the long-run.
To make an educated choice between traditional and Roth deferrals, you want to consider your current tax situation and your anticipated situation in retirement. In general, you want to choose traditional deferrals if you expect your tax rate to decrease in retirement and Roth deferrals if you expect it to increase.
There’s no way of knowing what taxes will be, so one way to hedge your bets is to use both a traditional and a Roth 401(k). You can divide your contributions between the two any way you want. You just can’t do more than the limit in a given year. Also consider that matching contributions from your employer have to be deposited into the traditional 401(k) account.
Another consideration is the pro-rata tax. This rule applies when an individual owns other pre-tax retirement accounts, such as Rollover IRAs, Traditional IRAs, SEP IRAs, and SIMPLE IRAs. The values of these accounts may determine how much of your backdoor Roth conversion will be taxed. If someone completes a rollover from a traditional 401(k) to traditional IRA and then later has to do a backdoor Roth IRA contribution it can create additional taxes owed. If that money was initially in a Roth 401(k) the pro rata rule will have less of an impact.
It can be tough to pass up a tax break by choosing Roth over traditional deferrals, but you need to think ahead when saving for retirement. Paying taxes now might help you save thousands – or even tens of thousands – in net taxes. That is additional money that can come in handy in retirement.
Make sure to consult with a CPA about your tax situation and what type of 401(k) contribution makes sense for you.
Christopher Peterson is a Certified Financial Planner™ professional, NAPFA member, fee-only financial advisor and provides fiduciary advice to his clients. Peterson Wealth Advisory was established in 2008.