Should I maximize a Roth 401(k) account while limiting my traditional 401(k) contributions?
My company offers a traditional 401(k) option with a 6% match. They have also introduced a Roth 401(k) option with a 6% match. I was thinking of changing my contributions to maximize my Roth 401(k) account at $17,000 per year, while limiting my traditional 401(k) account to $1,000 per year, plus the 6% match I get from my company. Would this be advised?
Everyone is familiar with the cliche to not put all of your eggs in one basket. This is often referenced in the financial world to diversifiying your investments. Likewise it can be applied to diversifying your future retirement income as well. Traditional 401k/IRA, pension income, and. social security (depending on combined income) is taxed as ordinary income. It makes sense to have some tax-free income in retirement from sources such as a Roth IRA and Roth 401k. Based on your retirement income needs you could manage your future taxes at retirement by withdrawing an amount of taxable income equal to the top amount in a particular tax bracket, without stepping up into a new marginal tax rate. The remainder of your annual income could then be withdrawn from your Roth’s without impacting your taxable income.
The question shouldn’t necessarily be if you should contribute to a Roth, but rather how much. As mentioned above the same principles apply to contributing to your traditional and Roth accounts. Contribute an amount to the traditional 401k that will bring your taxable income down below the current marginal tax bracket. The remaining contributions can then be directed to the Roth 401k.
Generally speaking this would help optimize your current pre-tax contibutions while balancing the flexibility of your future taxable income. Nobody knows what future tax rates will be, but having flexibility allows you to adjust as necesssary. Additionally, just because someone might be generating a lower income in retirement does not necessarily mean that they will be in a lower tax rate. We are currently in a relatively low tax environment and Congress can sometime again raise rates in the future. In other words your taxable income could possibly go down in retirement while the current tax bracket that you fall-in could increase.
A comprehensive fee-only CFP® professional can help you with your specific situation.
This is a great question and one we see fairly often. The answer really depends on your financial plan and what tax bracket you believe you will be in during retirment.
In short, if you believe you are in a higher tax bracket now than you will be in retirement then the traditional 401(k) would be a better option for you. However, if you believe that you will be in the same or higher tax bracket in retirment your strategy will work well.
The reality is that you can only base this upon current tax rates and we do not know what they will be in the future. Due to this uncertainty, it may make sense to have monies in both the Traditional and Roth 401(k) options to hedge rates in the future.
I would suggest engaging a fiduciary advisor to work with you on developing a plan and testing various scenarios based upon your current fact and where you want to be in the future. Best of luck as you work through this process!
Congratulations on maximizing contributions into your employer’s plan and being a diligent saver. Know there is a catch-up provision, if you are 50 years or older, which allows those folks to contribute an additional $6,000 in 2017 for a total employee contribution of $24,000 (vs. $18,000 for under 50).
Now to your question…really the argument is pay tax now on a known dollar amount at a known rate, versus pay tax later on a potentially larger sum of money at an unknown rate. I pose the argument as such since we know what the current tax rates and brackets are (or will be if the current tax plan becomes law). But we don’t know what future leaders might do with rates – they could be higher or lower than current. We would also assume that your money should grow over time, but that is not a given as it is incumbent on the underlying investments, markets, etc... But running under the assumption that money should grow over time, your contributions should grow over time and you will have be faced with potentially paying tax on a larger balance (traditional) or not paying tax (ROTH).
If you contribute to a traditional 401(k) you are reducing your current taxable income by that amount. As an example, you contribute $18,000 and are in the 25% tax bracket; this will save you $4,500 in taxes today. Conversely, if you choose the ROTH 401(k) option and place the same $18,000 into the account you will have to pay tax on the $18,000 contribution, since it will still count as income, but you will not pay tax on a later date (assuming you follow the withdrawal provisions for the ROTH 401(k)). The employer match is not really part of the equation since the employer cannot make an after-tax contribution on your behalf. Their contribution must go into the traditional 401(k) account and as a result you will still be responsible for paying tax on this piece in the future.
In conclusion, it is best to make plans given the rates and tax law we know today. Invariably, the current known tax information is the best we have to plan with as it is known. The next consideration is whether you believe you will be at a higher rate in your working years or in retirement. Depending on how long you have until retirement, you may or may not have Social Security, you may or may not have/had a job that provides a pension. If you are going to pay for 100% of your living expense in retirement from your 401(k) and estimate your cost of living to be the same it is today, you may be in the same tax bracket as today and this is an often overlooked fact. The traditional 401(k) withdrawal in retirement will count as ordinary income and thus be taxed as such, the ROTH 401(k) will not. Now if you believe your expenses will be lower, you will have other options to satisfy retirement cost of living (savings accounts, taxable investment account, etc…) and will be in a lower tax bracket then the sticking with the traditional option would be more beneficial.
Please note that the above is some general advice and should be treated as such. I would require a great deal more information about you and your personal situation in order to provide advice specific to you. Happy to answer any further questions you may have.
This depends on if you foresee yourself in a lower tax bracket when you retire. If so, a higher contribution to a traditional account would be more advantageous. Another way to play both sides is to fully fund a Roth IRA if you can while you contribute to the traditional 401(k).