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Whether you’re a current employee or changing jobs, you may have to choose between pretax and Roth 401(k) contributions, and it can be trickier than you expect.
Here’s the difference: Pre-tax 401(k) deposits reduce your adjusted gross income, and the money grows tax-free, meaning you’ll pay levies on withdrawals. In contrast, Roth 401(k) contributions do not provide upfront amortization, but earnings are tax exempt.
However, there may be other tax trade-offs, so you’ll need to weigh the pros and cons before embezzling funds, say financial experts.
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About 86% of 401(k) plans offered a Roth account in 2020, up from 75% in 2019, according to the Plan Sponsor Council of America.
“Generally, the goal is to take deductions at a higher tax rate and distributions at a lower rate,” said certified financial planner Ken Waltzer, co-founder and managing partner of KCS Wealth Advisory in Los. Angeles.
If you anticipate more income or higher taxes in retirement, tax-free withdrawals of Roth contributions may be wise, and tax-deferred contributions may be better if you expect lower income and withdrawals.
But that’s not always a winning strategy, according to Michelle Gessner, Houston-based CFP and founder of Gessner Wealth Strategies.
“Investors are quick to reject the idea of making Roth contributions if they’re in a high tax bracket because they want the deduction that comes with making a regular 401(k) contribution,” she said.
However, the initial write-off may not be worth it if you’re worried about the consequences of required taxable minimum distributions, she said.
Social Security and Medicare Costs
When a person withdraws tax-deferred money from a 401(k), it increases their income, which can trigger Social Security levies and increase health insurance premiums.
The formulas for Social Security, Medicare Part B, and Medicare Part D taxes use what’s called modified adjusted gross income, or MAGI.
If half of your Social Security plus MAGI payments are over $34,000 ($44,000 for a joint filing), up to 85% of those benefits may be taxable.
However, the biggest problem for retirees above certain income levels may be the supplement for Medicare Part B, known as the Income-Related Monthly Adjustment Income, or IRMAA.
While the base Medicare Part B premium amount is $170.10 for 2022, payments increase once income exceeds $91,000 ($182,000 for co-filers). The calculation uses MAGI from two years ago.
Roth withdrawals, however, won’t show up on tax returns, Gessner said, meaning retirees don’t have to worry about those distributions driving up Medicare premiums.
Since no one can predict future tax rates, you can also consider creating a mix of before- and after-tax funds for diversification, experts say.
“It’s great when clients have both Roth and traditional retirement savings,” said Catherine Valega, CFP and wealth consultant at Green Bee Advisory in Winchester, Massachusetts.
If you have both before- and after-tax funds, it can give you more options for building an effective retirement income plan, she said.