By John Drachman
With the solvency of Social Security beyond 2037 an ongoing question, future retirees must continue to carefully navigate their retirement plan choices to ensure their future nest egg will generate a flow of periodic income they cannot outlive.
Choosing the right retirement plan strategy begins with weighing what can be set aside now against what one will be paying in taxes later.
For today’s employees, two of the most popular choices are traditional 401(k)s and its younger sibling the Roth 401(k) which first appeared in 2006. With some 70% of employers now offering Roth 401(k)s, according to Plan Sponsor Council of America’s 2019 annual survey of employers, it’s worthwhile for employees to compare each plan’s advantages and trade-offs.
- Traditional 401(k)s help lower taxes now while deferring future tax payments on contributions and investment earnings until money is withdrawn.
- Roth 401(k)s on the other handtax contributions as they are directed into the account. This way the money withdrawn is tax free, as long as you’ve had the Roth account for at least five years and the distributions were made after age 59½ – or in the event of a disability.
Career Stages Count
Peak earners nearing retirement might be better off taking their tax breaks today with pre-tax traditional 401(k) contributions. This way, you will pay income taxes at your lower, post-retirement tax bracket instead of during your high-income years just before leaving the workforce.
In contrast, for those in the early stages of a career – and a presumably lower income tax bracket – the Roth option can be more appealing because it lets you lock in income tax rates today that could be lower during retirement when you start to use your retirement savings. “It does come down to the taxes,” says Catherine Golladay of Schwab Retirement Plan Services. “Many young people, as they grow into their career, have the expectation that they will become higher earners and subject to a higher tax-bracket.”
Finance author Suze Orman points out that Roth 401(k) s may also offer more flexibility. Unlike the traditional option, you don’t ever have to take the Required Minimum Distributions (RMDs) for a Roth. The traditional account requires you to start taking money out at age 72. Penalties are severe for missed deadlines too – up to a tax rate of 50% on the amounts not withdrawn.
The Bottom Line
For those scrimping to put aside retirement funds while the burden of going full Roth is still too great, splitting contributions between a traditional and a Roth 401(k) may be the best choice. Sure, you’ll have to take RMDs after you turn 70½, but your Roth 401(k) withdrawals will be tax free. “With a 50/50 split you are maximizing your diversification strategy,” Ms. Golladay added. “Even if you don’t know what tax bracket you’ll be in once you’re retired, you have the best of both worlds.”
While pondering which approach to take – traditional 401(k) or Roth – it’s a good idea to consult with a financial advisor. Many retirement specialists can also help you with other retirement-related questions – like how best to balance the long-term impacts of RMDs and withdrawal rates against other sources of income from Social Security or pension payments.
John Drachman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. John is an IABC award-winning writer, who applies his 30 years of financial marketing experience toward advancing the dialog between investors and investment professionals.