We’re in our mid-50s and have $2 million in our 401(k)s. Should we switch to Roth contributions?

Ask an Advisor: We're in our mid-50s and have $2 million in our 401(k)s. Should we switch to Roth contributions?

We're a dual-income couple, mid-50s and over $2 million in our 401(k)s. Should we ‘sacrifice' the pre-tax benefit and switch to Roth contributions in the workplace?

-Wendy

As with most tax-related questions, the answer is, “It depends.” Depending on your situation, switching contributions to a Roth 401(k) might make sense for a few important reasons, including tax diversity and tax-free growth. However, there may be additional factors that make it more desirable to stick with a traditional 401(k) and open a Roth IRA on the side. You should also consider the tax implications of your choice versus Pay Now or Pay Later. Many factors and assumptions (like future tax rates) go into these calculations, but it's worth finding out which way will save you the most tax over your lifetime.

There is no one-size-fits-all answer to this, so it makes the most sense to discuss this with a financial advisor or accountant. They have advanced modeling programs that allow you to see the different tax implications of staying with a traditional 401(k) account versus switching to a Roth account. (And if you're interested in working with a financial advisor, this tool can help you find a suitable partner.)

What is a Roth 401(k)?

More employers than ever are offering Roth 401(k) plans as part of their benefits packages. These hybrid accounts combine features of traditional 401(k) plans and Roth IRAs, giving you a company retirement option with special tax-free growth features. However, these plans have not yet fully caught on. Most of the money in employee retirement accounts is in traditional 401(k) shows, largely because people generally prefer the “pay less tax now” model.

Unlike a regular 401(k), contributing to a Roth 401(k) does not reduce your current tax burden. These contributions are made with after-tax dollars, so you pay taxes up front and get a huge benefit later. The compromise is tax-free growth. Therefore, if you follow all the rules, you will not have to pay taxes when withdrawing income from the account.

Transferring some or all of your contributions to a Roth 401(k) gives you greater tax diversity. If you choose a hybrid approach, part of your money will be taxable upon withdrawal (Traditional), while another part will be tax-free (Roth). This gives you more flexibility in future tax planning, another important benefit. (A financial advisor can help you determine if a Roth 401(k) is right for you.)

Advantages and disadvantages of a Roth 401(k)

Ask an Advisor: We're in our mid-50s and have $2 million in our 401(k)s.  Should we switch to Roth contributions?

Ask an Advisor: We're in our mid-50s and have $2 million in our 401(k)s. Should we switch to Roth contributions?

Roth 401(k)s, like any other type of retirement account, have advantages and disadvantages. For most people, the pros outweigh the cons. But the biggest downside — a higher tax burden today — might outweigh these benefits.

First, let's look at the benefits of Roth 401(k) plans:

  • Tax-free earnings growth (in most cases)

  • Thanks to the SECURE 2.0 Act, minimum distributions (RMDs) from Roth 401(k)s are not required for individuals turning 73 years of age after December 31, 2023

  • No income restrictions on contributions to a Roth 401(k)

  • Tax-free distributions on money properly withdrawn from your Roth 401(k).

  • Lower adjusted gross income (AGI) in the future, which may increase your eligibility for things like tax-free Social Security benefits

Now for the cons:

Here's a tricky feature that could go both ways: Matching contributions to Roth 401(k)s have historically been made on a pre-tax basis. In this case, you pay no current income taxes on the game, but you would be taxed on that money and any income if you withdraw it in the future. However, the SECURE 2.0 Act gives employers a new way to deposit these appropriate contributions into the Roth 401(k) account, simplifying finances for their employees. Check with your employer about how they handle Roth 401(k) matches. (And if you need help planning your retirement, this tool can help you find a financial advisor.)

Roth 401(k) vs. traditional 401(k)

Ask an Advisor: We're in our mid-50s and have $2 million in our 401(k)s.  Should we switch to Roth contributions?

Ask an Advisor: We're in our mid-50s and have $2 million in our 401(k)s. Should we switch to Roth contributions?

Now that you understand the pros and cons of Roth 401(k) accounts, let's look at how they compare to traditional 401(k) accounts.

The main difference between the two is the tax timing. With a traditional 401(k) plan, you deposit dollars before taxes, so the money you deposited now doesn't count as taxable income. You pay income tax when you withdraw the money. With a Roth 401(k), you deposit dollars after taxes and the money deposited counts as current taxable income. If you withdraw these contributions and the associated income, they will not be included in your income and you will not pay taxes on them (provided the money is properly withdrawn).

Advance withdrawals are also treated differently. With a traditional 401(k), distributions made before the age of 59 ½ may incur a prepayment penalty of 10% on the total amount. On a Roth 401(k), withdrawals are prorated between contributions and income, and the 10% penalty applies to the income portion only.

Another important difference: RMDs. Both types currently require RMDs, but that will change soon. Once you turn 73, you must withdraw RMDs from traditional 401(k) accounts. Beginning in 2024, individuals turning 73 after December 31, 2023 will not be required to withdraw RMDs from Roth 401(k)s. (And if you need help planning RMDs, consider working with a financial advisor.)

Roth 401(k) vs Roth IRA

While they share some important similarities, Roth IRAs and Roth 401(k)s have some equally important differences.

Roth IRAs have strict income limits that prevent many people from contributing. In 2023, individuals earning more than $153,000 or couples earning more than $228,000 cannot contribute to Roth IRAs. Anyone can contribute to a Roth 401(k) regardless of income.

Roth IRAs also have significantly lower contribution limits. The maximum contribution for 2023 is only $6,500, or $7,500 if you are 50 years of age or older. The maximum contribution for a Roth 401(k) is US$22,500 or US$30,000 if you are 50 years of age or older. Additionally, Roth 401(k)s offer the potential for employer matches not available for Roth IRAs. (And if you need help choosing a retirement account, you should speak to a financial advisor.)

Next Steps

There is a lot to consider when choosing between traditional and Roth 401(k) accounts. To make the best possible decision based on your individual financial situation, speak to your financial or tax advisor.

Tips for finding a financial advisor

  • If you have specific questions about your donation and tax situation, a financial advisor can help you. Finding a financial advisor doesn't have to be difficult. SmartAsset's free tool puts you in touch with up to three verified financial advisors operating in your area, and you can interview the appropriate advisors for free to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.

  • Consider a few advisors before deciding on one. It's important that you find someone you trust to manage your money. As you weigh your options, it's a good idea to ask an advisor these questions to ensure you're making the right choice.

Michele Cagan, CPA, is a financial planning columnist at SmartAsset and answers readers' questions on personal finance and tax topics. Do you have a question you would like answered? Email [email protected] and your question may be answered in a future column.

Please note that Michele is not a participant in the SmartAdvisor Match platform and has received compensation for this article.

Photo credits: ©iStock.com/courtneyk, ©iStock.com/designer491

The post Ask an Advisor: We're in our 50s and have $2 million in our 401(k)s. Should we switch to Roth contributions? appeared first on the SmartAsset blog.

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