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If you have a 401(k) plan, one of the biggest questions is whether to make pretax or Roth contributions, and the answer can be complicated, experts say.
While pre-tax 401(k) contributions reduce your adjusted gross income, you’re taxed on the growth when you withdraw them. By contrast, Roth 401(k) deposits don’t provide an upfront tax deduction, but the money can grow tax-free.
About 80% of employer retirement plans will offer Roth contributions in 2022, up from 71% in 2018, according to a recent report pioneer report Based on approximately 1,700 retirement plans.
While current and future tax brackets are one piece of the puzzle, experts say there are other factors to consider.
“Broadly speaking, it’s hard because there are so many factors to consider in making that decision,” said Ashton Lawrence, a certified financial planner with Mariner Wealth Advisors in Greenville, South Carolina.
Here’s how to determine which 401(k) plan is best for you.
Current and future tax brackets
One of the important questions to consider is whether you want to retire in a higher or lower tax bracket, experts say.
In general, pre-tax contributions are better for higher earners because of the upfront tax deduction, Lawrence said. But if you’re in a lower tax bracket, it might make sense to pay your taxes with a Roth deposit now.
If you’re at 22% or 24% or lower, I think a Roth contribution would make sense, assuming you’ll be at a higher level in retirement.
Lawrence Pang
Pon & Associates CPA
Lawrence Pon, CFP and CPA of Pon & Associates in Redwood City, Calif., explains that Roth 401(k) contributions are often beneficial for younger workers looking to earn more later in their careers.
“If you’re at 22% or 24% or lower, I think a Roth contribution would make sense, assuming you’ll be at a higher level when you retire,” he said.
There will be a “low tax sweet spot” by 2025
Although it is unclear how Congress will change tax policy, several provisions of the 2017 Tax Cuts and Jobs Act Planned to be eliminated in 2026, including lower tax brackets and higher standard deduction.
Those shifts in expectations could also affect the analysis of pre-tax versus Roth contributions, experts said.
“We’re in the sweet spot for low taxes,” said Catherine Valega, CFP founder of Green Bee Advisory in Boston, referring to the period before tax brackets are likely to rise. “I said taxes were for sale.”
We are in the sweet spot for low taxes.
Catherine Vallega
Founder of Green Bee Consulting
While Roth’s contributions are “as a matter of course” for younger low-income earners, she said the current tax environment also makes those deposits more attractive to higher-income clients.
“Some of my clients can make $22,500 in three years,” Valega said. “It’s a pretty nice change and it’s tax-free.”
Additionally, recent Secure 2.0 changes have made Roth 401(k) contributions more attractive to some investors, she said. Plans can now offer Roth employer matches, and Roth 401(k)s no longer require minimum distributions. Of course, plans may vary depending on the features an employer chooses to employ.
Consider your “legacy goals”
Mariner Wealth Advisors’ Lawrence says “estacy goals” are also a factor when deciding between pretax and Roth contributions.
“Estate planning is becoming a big part of what people actually think about,” he said.
Tax planning has gotten trickier since the SAFE Act of 2019 Inherited IRAs. Previously, non-spousal beneficiaries could “extend” withdrawal periods during their lifetime. But now, they have to deplete the inherited IRA within 10 years, known as the “10-year rule.”
Withdrawal schedules are now “tighter, which could affect beneficiaries, especially if they’re at their peak income,” Lawrence said.
However, Roth IRAs can be “a better estate planning tool” than traditional pretax accounts because non-spousal beneficiaries don’t pay taxes on withdrawals, he said.
“Everyone has their preferences,” Lawrence added. “We’re just trying to provide the best options for what they want to achieve.”
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