Saving for retirement is a key concern for most of your clients. Helping them make the best choices for where to direct their retirement savings is an important component of the advice that you provide to them. One such choice is whether to contribute to a traditional 401(k) account or to a Roth 401(k) option.
What Is a Traditional 401(k)?
A traditional 401(k) account offers clients the ability to make pretax contributions to their account. This provides a current-year tax benefit and allows the investments in the account to grow tax-deferred until withdrawals are made from the account. Distributions are subject to taxes at the client’s ordinary income tax rate, plus a penalty for withdrawals prior to age 59 ½ with a few exceptions.
Traditional 401(k): Pros
The ability to contribute on a pretax basis can be a huge benefit for all clients, but especially those in higher tax brackets. With the Biden administration proposing additional taxes on higher-income taxpayers, this tax benefit could prove even more valuable.
The ability to defer investment gains can be a big advantage as well. There are no current-year capital gains taxes to worry about. For clients who are likely to be in a lower tax bracket in retirement, they would pay taxes on these gains at a lower rate down the road. The power of being able to compound investment gains over time is a key advantage as well.
Traditional 401(k): Cons
The ability to defer taxes on these funds until retirement can also be a drawback. Many clients could potentially be in a higher tax bracket in retirement. Having to withdraw this money at that point could cause a larger portion of these retirement savings to be eroded by taxes.
What Is a Roth 401(k)?
A Roth 401(k), also known as a designated Roth account, is a Roth option that is offered by a growing number of 401(k) plan sponsors. Just like a Roth IRA account, contributions to a Roth 401(k) are made on an after-tax basis. Investments in the account grow tax-free until retirement, when they can be withdrawn tax-free if your client is at least 59 ½ and the five-year rule has been satisfied. Other rules may apply based on your client’s situation.
Any employer contributions, including matches or profit-sharing contributions, are deposited into a traditional 401(k) account in accordance with the rules for 401(k) plans.
Roth 401(k): Pros
One of the biggest advantages of a Roth 401(k) account is the fact that there are no income limits on your client’s ability to contribute to a Roth 401(k) account as there are with a Roth IRA. For clients who are looking to accumulate assets in a Roth account, this makes a Roth 401(k) an excellent planning tool. Clients can easily roll their Roth 401(k) balance into a Roth IRA when leaving their employer. This will allow them to avoid required minimum distributions on this money.
Rolling the money over to a Roth IRA also offers tax advantages for non-spousal IRA beneficiaries when they inherit the Roth IRA account based on the inherited IRA rules under the Secure Act.
A Roth 401(k) can be helpful in providing your client with tax diversification within their tax-advantaged retirement accounts. For clients who have the bulk of their retirement savings in traditional 401(k) and IRA accounts, this can provide an added level of tax diversification against potential future changes in the tax rules.
As with a Roth IRA, your client’s own contributions to their Roth 401(k) account can be withdrawn at any time tax- and penalty-free. A Roth 401(k) account is the vehicle that allows your clients to accumulate significant Roth account assets, which can be rolled over to a Roth IRA that facilitates a variety of planning options.
Roth 401(k): Cons
The biggest con with a Roth 401(k) is that they are subject to RMDs when account holders reach age 72. These RMDs are not taxed, but your client may wish to leave the money in the Roth account to continue to grow tax-free.
RMDs from a Roth 401(k) can be avoided by rolling the account over to a Roth IRA at an outside custodian. RMDs can also be avoided if your client is still working, they do not own 5% or more of the company and their employer has made the appropriate elections in their plan documents.
Under these circumstances RMDs can be deferred on the money held both in a Roth or traditional 401(k) account with that employer only, and only as long as your client is employed there. RMDs on any other retirement must be taken in accordance with the RMD rules.
Using Both Traditional and Roth 401(k)s
Your client can utilize both traditional and Roth 401(k) accounts separately or together. They can adjust their level of contributions to either type of account at any time. For example, if your client knows their income will be higher than normal in a particular year it could make sense to move all contributions to a traditional 401(k) account to tax advantage of the pretax contributions.
How much of your client’s total salary deferral to contribute to either or both types of 401(k) account should be an issue that is reviewed on a periodic basis as part of the planning work you do with your clients.
Traditional and Roth 401(k)s for Self-Employed Clients
The same pros and cons of traditional and Roth 401(k) accounts apply to self-employed clients using a Solo 401(k) plan.
The combination of a traditional and Roth 401(k) option can open a lot of planning avenues for your clients. They look to your expert advice to guide them to the most advantageous path for their 401(k) contributions.
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