3 Questions to Ask Yourself if You Have a Roth 401(k)
There are a few critical choices we make about our retirement accounts including how much to contribute and what to invest in. Due to the rise in popularity of Roth 401(k)s, you might have one other important decision: should you contribute pre-tax money to your traditional 401(k), post-tax money to your Roth 401(k), or have a mix of both?
Spoiler alert: everyone’s situation is different and there may not be a clear best choice. To decide, you’ll need to make some educated guesses about your answers to the following questions:
Do you think you will spend more annually in retirement than you currently earn?
Right now, you are taxed on how much income you earn. Once you stop working, your “income” will mainly be what you withdraw from your retirement accounts (unless you have other sources of income such as rental properties). Your expenses will be the main determinant of how much you need to withdraw. Conventional wisdom suggests that if you expect to spend less in retirement than you currently earn, you could benefit tax-wise from making traditional 401k contributions. If you expect to spend more in retirement, you’d be better off paying the taxes now through Roth 401k contributions.
Do you think tax rates will change in the future?
Tax rates are not static—in the last 30 years, federal tax rates have changed 5 times. While it’s impossible to predict what will happen in the future, tax rates now are historically low. This might prompt some people to prefer to pay today’s rates if they anticipate rates rising in the future.
Might you have a larger than average retirement balance and not need to use it all?
The federal government does eventually want its money, so at age 70.5 you must start taking minimum required distributions (RMDs). This is a certain annual withdrawal you must take from your traditional 401(k) based on your age and the balance in your account. This applies whether or not you need the money. Roth 401(k)s have the same requirement, but you can easily avoid it by rolling over your Roth 401(k) into a Roth IRA. Avoiding these mandatory withdrawals means that your retirement can continue to grow until you actually need the money.
Final Thoughts
If you don’t have a clear answer one way or another to these questions, you are probably best off optimizing for tax flexibility, rather than trying to pay the lowest taxes overall. You can create tax flexibility (aka tax diversification) by contributing to both types of accounts, rather than just one.
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