Too much choice can sometimes be a bad thing in life and it is no different in saving for retirement. 401 (k), Roth 401 (k), IRA, Roth IRA If the many types of retirement accounts leave you confused and overwhelmed, you are not alone.
Analysis paralysis is a real thing for many Americans. For example, the more options available in a 401 (k) employer plan, the less employees tend to participate, according to research from Columbia University and The Vanguard Center for Retirement Research. And even if more than 72% of corporate retirement plans offer Roth options, less than 8% of employees benefit, according to one report by T. Rowe Price. A big reason? People don't understand them.
If you're wondering how to choose between a traditional 401 (k), a Roth 401 (k) and a Roth IRA, here are three steps to help you decide.
Refresh the differences
Both Roth and traditional accounts offer tax advantages. The difference is when you take advantage of these benefits.
In a traditional 401 (k) and a traditional IRA, you pay no tax on the money you put in, up to the annual contribution limit of the accounts in 2020, it's $ 19,500 for a 401 (k) ($ 26,000 after the age of 50) and $ 6,000 for an IRA ($ 7,000 after the age of 50).
But you have to pay taxes when you withdraw from the account after age 59. In essence, you are pushing your taxes back to your retirement years, when the money you withdraw will be taxed as ordinary income, said Kelli Click, president of STRATA Trust, an IRA custodian. This is why these accounts are called tax-deferred, she said.
The tax benefits of Roth IRAs and Roth 401 (k) s work in reverse order. The money you contribute is taxed in advance, so anything you withdraw in retirement will be tax-free, as long as you leave it in the account for at least five years, said Click. .
There are also differences between Roth IRAs and Roth 401 (k):
First, Roth IRAs have income limits, unlike Roth 401 (k). You can only contribute to a Roth IRA if your modified adjusted gross income (MAGI) is less than $ 124,000 (gradually between $ 124,000 and $ 139,000).
On the other hand, there is no income limit for Roth 401 (k), so even very high earners can participate. But there is a catch: you can only invest in a Roth 401 (k) if your employer offers it.
Choose between Roth and traditional accounts
So how can you decide if you should use a traditional or Roth account? Typically, counselors often ask if you plan to be in a higher tax bracket now or in retirement.
If you think you will earn more money in retirement or if you think taxes will increase in the future for tax or other reasons, many advisers would recommend that you add a Roth option to your wallet. That way, you will get the tax benefit in the future, when your taxes are likely to be higher. In the opposite scenario, if you think your taxes will be lower in retirement, the advice would be to invest in traditional accounts.
Still, there are other individual factors that could come into play, which could change both your current cash flow and your future vision for retirement, said Andrew Meadows, senior vice president at Ubiquity, a provider plan 401 (k).
We all have different paths, said Meadows. For example, if your employer offers a 401 (k) match, it would make sense to take it because their money is free. If your family is growing and you suddenly have more mouths to feed, you may need to maximize your tax savings here and now. Or perhaps you are young and healthy, with many years of work ahead of you. You could say yes, I plan to be very successful in my life, said Meadows, and choose a Roth account to maximize your tax benefits during your golden years.
In any case, the rule of thumb is to save as much as possible because you are betting on the power to compose, according to Meadows.
If in doubt, diversify
If you still feel unable to choose, you are not alone.
There has been no evidence that tax-deferred growth is better or worse (than tax-free growth). Only time will tell, said Jason Grantz, director of Institutional Retirement Consulting at Unified Trust Company. In other words, unless you have a crystal ball, there is really no surefire way to predict if you will be in a higher tax bracket at the retirement than the one you are currently in.
This is where the concept of fiscal diversification comes into play.
This basically means creating traditional and Roth accounts during your working years, so you have the option to choose from compartments that are treated differently from a tax perspective, said Grantz. This would include not only tax-deferred (traditional) and non-taxable (Roth) accounts, but also taxable accounts, which are subject to capital gains tax.
There are many ways to do this to get the most out of your savings. You can maximize your 401 (k) at work and on top of that, open up and make the maximum contribution to a Roth IRA as long as you make it below the Roth IRA income limits (see above).
Or you can split your 401 (k) contributions between a traditional and a Roth 401 (k) equally or in any combination that works for you as long as the combined total does not exceed the annual contribution limit of $ 19,500 or $ 26,000 after the age of 50.
There are many other ways to combine accounts. And if the circumstances of life change, you can change your mind and choose a different combination.
Dividing your money between accounts with different tax treatments means that you will be ready, no matter which direction the taxes go in the future. It also allows you to do something called tax bracket management, which reviews several years together to smooth the receipt of income in order to reduce the overall tax burden.
Finally, when you start to withdraw money, be sure to consult with a tax accountant on the smartest way to make withdrawals to minimize your tax bill.
