If you’re saving for retirement at work, one smart move can make your balance even stronger. Invest at least some of your cash in a Roth 401(k).
More than 8 in 10 employers now offer two kinds of 401(k)s to choose from, according to a Callan Institute 2019 Defined Contribution Trends report: a traditional 401(k) and a Roth 401(k). Most savers use the traditional options, but the Roth can be the smarter choice over the long term.
“If you can save in a Roth 401(k), consider yourself lucky,” says John Iammarino, a financial advisor at Securus Financial in San Diego. “My message is Roth all day, every day, if you can.”
Here’s what you need to know as you strategize.
With a traditional 401(k), your contributions come with an up-front tax break. Every dollar you contribute is deducted from your income, reducing your current-year tax bill. You then pay tax in retirement, when money you withdraw will be taxed as ordinary income.
A Roth 401(k) front loads your tax bill. You pay tax today by making your contributions from salary that is first run through the tax-collection machine. The happy ending here is that in retirement you will not owe any tax on money you withdraw.
So if you hit retirement with $500,000 in a Roth 401(k), you have $500,000 to spend. If you have $500,000 saved in a traditional 401(k), you might have around $400,000 or so to use after paying tax, based on current tax rates (which, by the way, are quite low).
Younger workers stand to benefit the most from using a Roth 401(k).
“Putting away money today that can then grow tax free for decades is so valuable,” says Skip Johnson, a founding partner at Great Waters Financial, an advisory firm with offices across the Minneapolis region.
If you’re not at peak earning level yet, you are likely in a lower tax bracket now than you will be at retirement. Plus federal income tax rates are near historic lows.
“We like to show clients a historical chart of tax rates,” says Johnson. “Then they get it when we say, ‘My goodness, taxes are on sale right now, so let’s take advantage by using a Roth.’”
Many employers automatically enroll new employees in a retirement plan. But a quirk of auto enrollment is that it plunks workers into the traditional 401(k), even when a Roth 401(k) is an option.
If you habitually ignore the annual open enrollment missives from HR, you likely missed the news that you can choose a Roth.
No worries. Now you know. It’s easy to ping HR and request that some or all of your future contributions be made into a Roth 401(k) account. And make a mental note right now that every time you start a new job you will check to see if there’s a Roth option.
Even if you go all in with a Roth 401(k), you will likely still have money in a traditional 401(k). That’s because employers that make a matching contribution typically insist their money goes into a traditional 401(k) account in your name. Yes, you will have to pay tax on that money, but owing some tax on what was essentially a gift of money is a small price to pay.
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