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Sometimes it’s better to get taxes out of the way earlier when using a 401(k) to save for retirement.
Financial planner David Born of Orinda, Calif., advises a couple in the top tax bracket who contribute to Roth 401(k)s rather than traditional 401(k)s, even though it means they pay more in taxes now.
The husband and wife have a net worth of $30 million because they worked at tech startups and were given shares before they exploded in value, Born says.
They are contributing to a Roth 401(k) because they figure they’ll never be in a lower tax bracket, he says. And they know that a Roth 401(k), unlike a traditional 401(k), can be left to their heirs tax-free.
“Anyway you slice it, they’re coming out better by doing a Roth rather than a traditional 401(k),” Born says.
With a Roth 401(k), income is invested after taxes have been taken out, instead of before as with a traditional 401(k). Distributions from a Roth 401(k) are tax-free, while distributions from a traditional 401(k) are taxed as regular income.
The conventional wisdom is that you shouldn’t contribute to a Roth 401(k) if you’re in a high tax bracket, but more Americans are doing so anyway, financial advisors say.
Some like Born’s clients do it because they figure they’ll always be in a high tax bracket, while others worry that taxes are heading up the future and they are better off paying the taxes now. Still others fear their retirement income will be distorted by big required minimum distributions if they accumulate too much money in a traditional tax-deferred 401(k).
“A required distribution, often for clients that don’t need the money, can push them into a higher bracket and make things complicated,” says Michael Landsberg, a financial planner in Punta Gorda, Fla.
Unlike Roth individual retirement accounts, Roth 401(k)s have no income limits and you’re able to contribute up to $19,500 a year. Workers over 50 can contribute up to $26,000 a year.
By contrast, the maximum you can contribute to a Roth IRA is $6,000 a year, or $7,000 if you’re over 50. And as your income rises, the amount of money you can contribute to a Roth IRA dwindles to zero.
To be sure, Roth 401(k)s aren’t good choices for many top earners. Those close to retirement often come out ahead by contributing to a traditional tax-deferred 401(k) and then converting it to a Roth IRA after they are retired and are in a lower tax bracket.
Roth accounts frequently don’t make sense for the charitably minded. After age 70½, you are able to give directly from tax-deferred accounts to charity through qualified charitable distributions, notes financial advisor Christopher Hershey of Lancaster, Pa. “These gifts count toward satisfying your required minimum distribution and can significantly reduce the tax bite once your RMDs start at age 72,” he says.
But Roth 401(k)s are worth considering for many other highly paid workers. Here are six reasons why one may make sense for you:
Your tax rate will never be lower. The biggest reason not to fund a Roth 401(k) is if your tax rate will be lower when you take money out of the account in retirement. If so, you’re better off sticking the money in a tax-deferred account.
But if you’re really wealthy, you’ll still be at a top rate for your entire life. Thus, you might want to bite the bullet and pay taxes now and see the money grow tax-free for decades.
“It is very often the case that those subject to the highest rates working will also be subject to those same rates when retired,” says financial planner Dave Yeske of San Francisco. “That makes the Roth option attractive.”
You fear taxes are going up in the future. Taxes are currently low by historical standards, but the government has spent trillions of dollars during the pandemic and taxpayers will need to pay the bill. Many fiscal experts think that taxes—particularly for the rich—are headed up.
If your money is in a Roth, it should be insulated from future tax increases. Yes, the government could tinker with Roth rules, but imposing taxes on Roth distributions would be a huge betrayal of trust, and few are predicting it.
It’s a form of forced savings. When you fund a Roth, you are using after-tax money. The bottom line is that you are saving more money for the future than if you made the same-sized contribution to a traditional 401(k) and still owe taxes down the road.
“If you can’t save any money outside of your 401(k), then a Roth 401(k) can make more sense to do even if it isn’t as tax efficient as a traditional 401(k) contribution,” says Larry Pershing, a Chicago financial planner.
High RMDs will push you into higher tax brackets. At age 72, you must begin taking required minimum distributions from a traditional 401(k). Required minimum distributions, or RMDs, can push you into a higher bracket for income taxes and for Medicare premiums.
You also must begin taking RMDs from a Roth 401(k) at age 72, but the distributions aren’t taxable and have no effect on your income taxes or Medicare premiums. Even better, you can roll that Roth 401(k) into a Roth IRA and have no required distributions for the rest of your life.
You want to leave money to your heirs. Roth accounts pass tax-free to your heirs, unless your estate exceeds the $11.7 million lifetime estate exemption. Until recently, heirs had the rest of their lives to empty inherited Roths. Now most heirs must empty them in 10 years, but it’s still a great way of transferring wealth. Spouses and certain others aren’t subject to the 10-year distribution rule.
If you leave a traditional 401(k) to your heirs, they must also empty it in 10 years. But your heirs will pay taxes on every dime they take out. If you’re leaving money to children who are still in their prime working years and in a high tax bracket, they could owe a lot of taxes.
Roths are simpler and more flexible. Some people embrace Roths because they are less complicated than tax-deferred accounts. They don’t have to worry about taxes going up before they begin withdrawing money. They don’t have to worry about RMDs. They have paid the taxes, and money will grow tax-free for the rest of their lives.
“There’s an emotional component that needs to be quantified,” says planner Ashlee deSteiger of Birmingham, Mich. “Even if you are in a high tax bracket, knowing that you can take the money out tax-free at a later day or pass it along to your heirs tax-free brings tremendous peace of mind.”