When you talk to your accountant this tax season, it’s also a great time to decide how you’ll contribute to your employer-sponsored retirement plan this year.
You might first have the option to choose between a traditional 401(k), and a Roth 401(k). Roth contributions are made on an after-tax basis, and traditional contributions are made on a pre-tax basis. (Your employer will deduct 401(k) contributions directly from your paycheck regardless of whether you opt for traditional or Roth.)
Traditional contributions reduce your taxable income for this tax year. Say you make $100,000 and contribute $15,000 in traditional form to your 401(k) plan. Your taxable income is immediately reduced to $85,000. Furthermore, the money you invest grows tax-deferred until you withdraw it at retirement. At retirement, you pay ordinary income tax on all traditional contributions and any gains.
Roth contributions won’t reduce your current taxable income. But there are no retirement-time taxes on Roth distributions. You pay taxes up front, and the rules today state gains aren't subject to taxation.
Deciding whether to Roth
People who are in their peak earning years just prior to retirement generally stand to benefit most from traditional contributions. In those high-earning years, traditional contributions could take you into a lower tax bracket and have a significant impact on your tax bill.
New workers in their early-to-mid twenties fall on the other end of the spectrum. Incomes are smaller, so contributions are smaller, and tax consequences are smaller as well. During those early earning years, there’s less need to jump down to a lower tax bracket, so it generally makes sense to make Roth contributions.
If you’re between 25 and 60, things are a lot grayer as tax and income situations vary widely. And tax laws could change drastically by the time you retire, so there isn't a perfect plan for deciding on Roth, traditional, or blended contributions.
You can, however, diversify to mitigate tax risks. In this case, I’m not talking about your asset class allocation—I mean tax diversification. You can blend so that you’re making Roth and traditional contributions. An even split may or may not work well for you. If you’re younger or area lower income-earner, you may tend toward Roth contributions; if you’re nearing retirement or are a higher income-earner, reducing your taxable income may be beneficial. But, ultimately, much of the decision hinges on whether you feel more comfortable paying taxes now or later and whether you’re willing to risk tax uncertainty during retirement years in exchange for a beneficial tax situation now.
Tax diversification is appropriate for nearly every retirement investor. The percentage split is the element that will vary based on your personal situation and comfort level. Either way, this is a good time to talk with someone that understands your tax burden.
Scott Holsopple is the president of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.