Clients often come to our retirement investment advisors with questions about Roth IRAs; how do they work? What are the differences between a Roth and a 401(k)? Which plan is best for my specific needs?
The good news is that you can take advantage of the Roth's "pre-paid" taxes feature now, so that you don't have to worry about paying taxes on that money -- or its investment gains -- in the future. This increases both your flexibility and your tax diversification in retirement.
Here's how the Roth 401(k) combo works.
Taxes and Strategic Financial Planning: Diversification is Key
In a perfect world, your tax burden would end when you left the workforce... but in reality, your taxes don't just end at retirement, they may actually get a bit more complicated. As a general rule, you'll withdraw from taxable and Roth accounts first, so you can put off paying taxes on your traditional retirement accounts for as long as you can.
But here's where it gets complex. If you wait too long to withdraw, your traditional account may grow enough so that your required minimum distributions push you into a higher tax bracket -- and you'll end up owing more at tax time. Diversification helps you avoid this problem; by investing in a range of different buckets, you can work with your wealth advisor to calculate different scenarios and optimize your after-tax income.
Financial Strategies: Roth Contributions are Worth More in the Long Run
Tax-sheltered accounts can actually allow you to save more money. Why? A dollar you contribute to a Roth is worth more than a dollar you contribute to pre-tax account, because that traditional account will eventually be taxed. For instance, if you've got $20,000 in a Roth, the whole balance belongs to you, as it won't be taxed again. But if you've got $20,000 in a traditional 401(k) that'll be taxed at a 15 percent rate, you'll end up with $17,000 in the end.
And one more thing: Currently, tax rates are near historic lows. If rates increase, your Roth account is worth even more, because you already paid taxes at the lower rate.
Mind Games: An Investment Management Solution Straight Outta Psych 101
When you pay taxes first, the balance in your Roth account may look a bit lower. Psychologically speaking, this may be the kick in the pants you need to shift your savings rate into full throttle mode. While a larger account balance may provide you with peace of mind -- or serve as some fabulous daydream fodder about all the wonderful things you're going to do when you're retired -- it often won't serve as a motivating factor to make you want to save more.
Tap into Your Roth Without Penalty
If you need to tap into your traditional 401(k) retirement accounts before age 59 1/2, you'll generally get hit with a 10 percent early withdrawal penalty. However, if you've had your Roth for at least five years -- and your employer allows in-service withdrawals -- you can tap into your account early. Plus, if you do a Roth 401k rollover to a Roth IRA, you can withdraw without penalty five years after the rollover is complete.
While every situation is different, many investors benefit from deferring taxes for as long as possible, as tax brackets are generally lower for those in retirement than for those in the work force. However, saving at least part of your retirement in a Roth 401(k) provides you with more flexibility, more options and greater diversification. Remember, your retirement plan advisor is here to answer your questions.