Roth 401(k)s are a no-brainer when you’re young, in a low tax bracket, and expect to earn a lot more in the future. Of course, you won’t get the tax deduction upfront, but that probably doesn’t matter if you don’t pay a lot of tax in the first place. Plus, you’re likely to more than compensate given the tax-free growth of your investments over the decades.
But even some older, higher-earning workers should consider mixing and putting money into a Roth 401(k) as well, especially given their higher contribution limits compared to traditional IRAs or Roth IRAs. Contributions to IRAs are capped at $6,000 ($7,000 for ages 50 and older), while total 401(k) contributions can be up to $20,500 ($27,000 for ages 50 and older ). Proposals before Congress would raise those 401(k) contribution limits even further for older savers and potentially treat them as after-tax.
Nearly 80% of companies’ 401(k) plans offered a Roth option as of June 30, up from 62% five years ago, according to Fidelity Investments. But only 14% of workers who were offered it contributed, compared to 10% five years ago. Vanguard data shows a similar story: 77% of plans offered a Roth 401(k) option in 2021, but only 15% of workers participated.
Part of the problem may be auto-registration. Many plans simply transfer workers into traditional 401(k) plans. This is not a bad thing since it encourages saving, but it would be better if employees were forced to make an active choice, especially given the magnitude of the benefits for young workers.
For high earners, the conventional thinking has always been that a Roth 401(k) is useless because they are likely to earn less in retirement and therefore be in a lower tax bracket (so pay less). taxes when they withdraw money). There are a few reasons why this is worth revisiting.
First, while you can be sure you’ll earn less in retirement, it’s risky to assume that tax rates in general will be lower. Personal income tax rates are relatively low right now and given the growing federal deficit, there’s a good chance they’ll head north at some point in the future. Also, if you are in a high bracket now, you can still be there even after you stop working through other sources of income.
It’s also prudent to give you different types of retirement accounts to operate, tax-wise. Then you have more flexibility around your taxable income, especially if you’re worried about hitting higher tax thresholds on Social Security benefits or certain Medicare costs. You can contribute to both types of 401(k) accounts or rotate which account you contribute to from year to year.
As with traditional 401(k)s, Roth 401(k)s require you to withdraw a certain amount each year once you reach 72 — called minimum required distributions — but with Roth 401(k)s, the money will only be not subject to income tax. There are also ways around these distros. If you are still working for your employer at age 72, you may not have to take them. Alternatively, if you meet certain conditions, you can carry forward the balance on a Roth IRA before you turn 72, as Roth IRAs have no distribution requirements.
If you’re sold on the idea of a Roth 401(k), you can transfer some or all of your money from a traditional 401(k) to a Roth 401(k) in what’s called a conversion to plan – but you better be sure, because there’s no way to go back. Still, this is a particularly good time to make a switch, as your account likely lost money amid the falling stock market. You will therefore pay less initial tax.
Still, there are a few caveats. You will be subject to taxes and a 10% withdrawal penalty if you withdraw investment earnings (not your contributions) from a Roth 401(k) before you have had the account for five years and if you do not you’re not yet 59 and ½ years old. So avoid setting one up if you plan to retire soon and are relying on that money.
Also: correspondence with the employer. Most companies will match the dollar value of their workers’ contributions up to a point, but they’ll put that money into their regular 401(k), even if the employee is contributing to a Roth 401(k). So be aware that everything your employer pays, as well as earnings, will be subject to retirement tax. In this case, even with a Roth 401(k), you will not be able to escape the tax authorities completely.
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This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she oversaw tax coverage for Bloomberg News.
More stories like this are available at bloomberg.com/opinion