Though they have been around since the 1970s, 401(k) plans are still one of the best ways to save for retirement. A 401(k) pension account gives employees the opportunity to automatically invest part of their income for the future, while also postponing their tax liabilities. In some cases, employers will match employee contributions to these accounts to maximize retirement savings.
However, the 401(k) savings vehicle has evolved a lot over the past two decades. Nowadays, many 401(k) plans allow for Roth contributions. You’re probably wondering: what exactly is a Roth contribution? And should you make Roth contributions inside your 401(k)? What are the benefits? We will discuss all of this and more, but first let’s look at how 401(k) accounts utilize Roth contributions.
What is a Roth Contribution?
A Roth IRA is a retirement account that allows your money to grow tax-free. While your contributions cannot be deducted from your taxes, you do not have to pay taxes on your earnings. As a result, your money can grow faster, free of tax obligations. Eventually, when you withdraw your retirement funds, you will not have any tax obligations on these withdrawals. Everything in this type of plan is yours to keep.
Benefits of Making Roth Contributions Inside of Your 401(k) Plan
When it comes to Roth contributions and 401(k) plans, many people are unsure how to get the most out of their money. Fortunately, there are a number of benefits to making Roth contributions. Let’s look at a few of the best reasons to make Roth contributions inside your 401(k) plan:
You can put more money in your plan - As of 2019, the contribution limit for ALL 401(k) plans is set at $19,000. That said, traditional contributions will eventually be taxed by the federal government at an unknown, potentially higher tax rate in the future. Let’s assume the tax rate during your retirement is 25%. This means that, with traditional contributions, you will be able to keep 75% of your $19,000 (or $14,250) when you retire. However, with Roth contributions, you can put the entirety of the $19,000 toward your retirement and allow it to grow in a tax-preferred account.
You can take advantage of low tax rates - The Trump tax cuts include a sunset provision, meaning that by 2026, the tax rates will almost certainly be higher than they are now. On top of higher tax rates, the current economic outlook is somewhat bleak; medicare costs are skyrocketing, social security is underfunded, baby boomers are hitting retirement and leaving the workforce rapidly, and our collective national debt is growing higher and higher every year. This means that the chances of an increased tax rate in the future are extremely high. The best way to prepare NOW is to grow as much "tax-free" money as possible. Accumulating "tax-deferred" money, may be a mistake, as tax rates will likely be much higher than you expect. What if, instead of 25% (for example), tax rates in your bracket climb to 35% or 40% (which is still much lower than some European countries)? You will be keeping much less of your $19,000 contribution. Being proactive with contributions might be the key between two different lifestyles in your retirement.
You can diversify your contributions - Company matching contributions will be tax-deferred traditional contributions, regardless of where you elect to put your own money. This means that if you choose Roth contributions, you will essentially have two buckets of funds inside your plan. This helps create tax diversification. If, for some reason, your tax rates do not turn out to be higher in retirement, you will still have some traditional contributions in you plan; so you can decide to distribute that money in years with lower tax rates instead. Having more than one bucket gives you OPTIONS, and these options allow you the flexibility to control an optimal income strategy for your retirement.
Are you looking for a financial plan that fits your circumstances and maximizes long-term benefits? Consult the experts at Afton Advisors today for more information!