To Roth or not to Roth?
Trying to figure out what type of 401(k), or IRA retirement account to use can be confusing. Thus the conundrum….To Roth or not to Roth?
There are 2 types of IRAs and 401(k)s: traditional and Roth. Since there are pros and cons to both, it usually makes sense to spend a few minutes researching which is best for you.
The decision often depends on whether it makes more sense to pay income tax now or once in retirement. However, since you don’t know what future tax rates will be, it’s not always an easy decision.
If you are in a high tax bracket today, and expect to be in a lower bracket in retirement, you might want to consider contributing to a traditional 401(k)/IRA (assuming you are eligible). In this case, you will get both tax-deferred growth potential and tax-deductible contributions. Because of the deductibility of the contributions, you save taxes now putting more dollars in your pocket “TODAY”. And who doesn’t want more money today?
But what will you do with those extra dollars you saved today by using the deductible traditional accounts? Will you use them to invest, pay down debt or perhaps make an improvement to your home? Or will you just buy a slightly nicer car because you can afford a higher payment? Or maybe go out for nicer dinners (sorry…I meant take out), take a few more shopping sprees (virtual of course) or buy more lottery tickets? No judgement here.
What if instead of contributing to your traditional 401(k)/IRA, you made your contributions into the Roth 401(k)/IRA knowing you would have less spending money now? With the Roth option, you contribute with after-tax dollars today but qualified withdrawals will be tax free in retirement. So you have a little less money for fun today in exchange for a potentially less taxing retirement income later.
If you’re struggling to determine whether to use traditional or Roth, you might want to consider “tax diversification” which is the practice of saving for retirement through a variety of retirement vehicles with different tax treatments.
For example, if you already have a traditional 401K balance, which is all pre-tax dollars, you might want to start deferring at least some of your future contributions into the Roth 401(k) option. That way, you’ll have some dollars in the account that will be taxed upon withdrawal and some that will be tax free.
So maybe you don’t have to decide whether to Roth or not to Roth after all. Perhaps you can consider both.
Be aware there is an earnings test to contribute to a Roth IRA but not for a Roth 401(k).
For 2020, the 401(k) contribution limit is $19,500. However, if at least 50, you can make additional $6,500 “catch-up” contribution. The 2020 IRA contribution limit is $6,000. (plus $1,000 catch-up for 50 and older).