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We are a dual income couple in our mid 50’s with over $2 million in our 401(k)s. Should we “sacrifice” pre-tax benefits and switch to Roth contributions at work?

Wendy

Like most tax questions, the answer is “it depends.” Depending on your situation, contributions are converted into a file Roth 401(k) It can make sense for several major reasons, including tax diversity and tax-free growth. However, there may be additional factors that make sticking with a traditional 401(k) and opening a Roth IRA on the side more desirable. You’ll also need to consider the tax impact of choosing between paying now versus paying later. Lots of factors and assumptions (such as future tax rates) go into these calculations, but it’s worth trying to figure out which path will save you the most in taxes over your lifetime.

There is no direct, one-size-fits-all answer to this question, so it makes sense to discuss this with your financial consultant or tax pro. They’ll have advanced modeling software that can help you see the different tax implications of sticking to a traditional 401(k) or switching to a Roth account. (And if you’re interested in working with a financial advisor, This tool can help you match with one.)

What is a Roth 401(k)?

More employers than ever before offer Roth 401(k) plans as part of their benefits packages. These hybrid accounts combine features Traditional 401(k) plans And Roth IRA, giving you the option to retire at work with special, tax-free growth benefits. However, these plans are yet to be discovered. Most of the money in employee retirement accounts is in traditional 401(k)s, mostly because people generally prefer the “pay less taxes for now” model.

Unlike a regular 401(k), contributions to a Roth 401(k) will not reduce your current tax bill. These contributions are paid in after-tax dollars, so you’re paying taxes upfront for a significant interest in the future. The trade-off is tax-free growth, which means if you follow all the rules you won’t have to pay any tax on the profits inside the account when you withdraw them.

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Moving all or part of your contributions to a Roth 401(k) gives you greater tax variety. If you choose a hybrid approach, some of your money will be taxed when you withdraw it (traditional), while some will be tax-free (Roth). This gives you more flexibility with future tax planning, which is another major advantage. (a financial consultant They can help you decide if a Roth 401(k) is right for you.)

Roth 401(k) Pros and Cons

A Roth 401(k) comes with advantages and disadvantages, just like any other type the retirement account. For most people, the positives outweigh the negatives. But the most significant drawback — today’s larger tax bill — can outweigh those benefits.

First, let’s take a look at the benefits of Roth 401(k) plans:

• Tax-free earnings growth (in most cases)

• no minimum distributions required (RMDs) from Roth 401(k)s for people who turn 73 after December 31, 2023, thanks to the SECURE Act 2.0

• There are no income restrictions for contributing to a Roth 401(k).

• Tax-free distributions on money you properly withdraw from a Roth 401(k)

• minimum adjusted gross income (AGI) in the future, which can increase your eligibility for things like tax-deductible Social Security benefits

Now for the drawbacks:

Here’s one tricky perk that can go either way: Matching contributions to Roth 401(k)s have historically been made on a pre-tax basis. In this case, you don’t pay any current income taxes on the match, but you will be taxed on that money and any winnings when you withdraw it in the future. but, Code Safe 2.0 It gives employers a new option to put those matching contributions into a Roth 401(k) account, streamlining their employees’ finances. Check with your employer to see how they handle Roth 401(k) matches. (And if you need help planning for retirement, this tool can help you align with a financial consultant.)

Roth 401(k) versus traditional 401(k).

Now that you understand the pros and cons of Roth 401(k)s, let’s look at how they compare to traditional 401(k) accounts.

The main difference between the two is the timing of the tax. With a traditional 401(k) plan, you contribute pre-tax dollars, so the money you put away doesn’t count as taxable income now. You will pay income taxes when you take the money. With a Roth 401(k), you contribute after-tax dollars and the money you put in counts as current taxable income. When you withdraw these contributions and the earnings on them, they will not be included in your income and you will not pay tax on them (if the money is withdrawn correctly).

Early withdrawals are also treated differently. With a traditional 401(k), distributions taken before age 59 may yield up to 10%. Early withdrawal penalties for the full amount. With a Roth 401(k), withdrawals are prorated to include contributions and earnings, and only the 10% penalty applies to the portion of the earnings.

Another important difference: RMDs. Both types require RMDs at the moment, but that is about to change. You must take RMDs from traditional 401(k) accounts once you reach age 73. But starting in 2024, people who turn 73 after December 31, 2023 won’t have to take RMDs from Roth 401(k)s. (And if you need help planning for RMD, Consider working with a financial advisor.)

Roth 401(k) vs. Roth IRA

While they share some important similarities, Roth IRAs and Roth 401(k) have some equally important differences.

Roth IRAs have strict income limits that keep many people from contributing. For 2023, individuals who earn more than $153,000 or couples who earn more than $228,000 cannot contribute to Roth IRAs. Anyone can contribute to a Roth 401(k), regardless of income.

Roth IRAs also have significantly lower contribution limits. the Maximum contribution for 2023 It’s $6,500, or only $7,500 if you’re 50 or older. the Maximum contribution to a Roth 401(k) It is $22,500 or $30,000 if you are 50 or older. In addition, Roth 401(k)s have the potential for employer matches that Roth IRAs do not. (And if you need help choosing between retirement accounts, Consider speaking with a financial advisor.)

next steps

There is a lot to consider when choosing between traditional accounts and Roth 401(k) accounts. To make the best possible decision based on your unique financial situation, talk to your financial advisor or tax professional.

Tips for finding a financial advisor

• If you have questions specific to your tax and gifting situation, a financial advisor can help. Finding financial consultant It doesn’t have to be difficult. Free SmartAsset tool It matches you with up to three vetted financial advisors serving your area, and you can interview your own advisors at no cost to determine which one is right for you. If you are ready to find a counselor who can help you achieve your financial goals, let’s start.

• Consider a few advisors before settling on one. It is important to make sure you find someone you trust to manage your money. When you consider your options, These are the questions you should ask a counselor To make sure you make the right decision.

Michelle Kagan, CPA, a columnist for SmartAsset financial planning and answers readers’ questions on personal finance and tax topics. Do you have a question you would like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.

Please note that Michelle is not a participant in the SmartAdvisor Match platform and has been compensated for this article.

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