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Understanding the Benefits of Pretax and Roth Contributions to Your 401(k)
Factors to Consider When Choosing Between Pretax and Roth Contributions
Experts recommend considering multiple factors when deciding whether to make pretax or Roth contributions to your 401(k). While pretax contributions reduce your adjusted gross income, Roth contributions provide tax-free growth. Additionally, the availability of Roth contributions in employer retirement plans has significantly increased in recent years.
Impact of Current and Future Tax Brackets
One crucial factor to consider is your expected tax bracket in retirement. Higher earners may benefit more from pretax contributions due to the upfront tax break. On the other hand, if your tax bracket is lower, making Roth contributions and paying taxes now can be a more favorable option. Financial planners suggest that those in the 22% or 24% tax bracket or lower should lean towards Roth contributions if they anticipate being in a higher bracket during retirement.
Changes in Tax Policy and the Low-Tax Sweet Spot
Expected changes in tax policy, such as the sunsetting of provisions from the Tax Cuts and Jobs Act of 2017, can also impact the decision between pretax and Roth contributions. Currently, tax brackets and the standard deduction are at relatively low levels. This low-tax sweet spot may make Roth contributions more appealing, as taxes are expected to increase in the future.
Benefits of Roth Contributions for Younger Workers and Higher-Income Clients
Roth contributions are often recommended for younger workers who anticipate higher earnings in the future. However, the current tax environment has made Roth contributions more attractive for higher-income clients as well. The ability to contribute a significant amount of money to a Roth 401(k) and enjoy tax-free growth is seen as a valuable option. Recent changes to retirement plans, such as those introduced in Secure 2.0, have further increased the appeal of Roth contributions, as plans now offer Roth employer matches and no longer require minimum distributions for Roth 401(k)s.
Estate Planning Considerations
The "10-year rule" introduced by the Secure Act of 2019 has affected tax planning for inherited individual retirement accounts (IRAs). Nonspouse beneficiaries must now deplete inherited IRAs within 10 years, which can have significant tax implications, especially for beneficiaries in their peak earning years. Roth IRAs can be a valuable estate planning tool as nonspouse beneficiaries can withdraw funds tax-free. It is essential to consider your legacy goals when deciding between pretax and Roth contributions and consult with a financial planner for personalized advice.
How Pretax and Roth Contributions to a 401(k) Impact New Businesses
When starting a new business, it is crucial to consider the impact of pretax and Roth contributions to a 401(k) plan. The choice between the two can have significant implications for both the business owner and its employees.
One key factor to consider is the expected tax bracket in retirement. For new business owners who anticipate being in a higher tax bracket during retirement, pretax contributions may provide a more significant upfront tax break. However, if the business owner expects to be in a lower tax bracket in the future, making Roth contributions and paying taxes now could be a wiser option. By doing so, they can take advantage of tax-free growth in their retirement savings.
Moreover, considering changes in tax policies is essential for new businesses. As tax brackets and deductions are currently at relatively low levels, this presents a "low-tax sweet spot" that makes Roth contributions more appealing. Expected future increases in taxes make it prudent for new business owners to consider the benefits of Roth contributions in their retirement planning.
Younger workers and higher-income clients also stand to benefit from Roth contributions. With the ability to contribute a significant amount of money to a Roth 401(k) and enjoy tax-free growth, new business owners in these categories can optimize their retirement savings. The recent changes introduced in Secure 2.0, such as offering Roth employer matches and eliminating minimum distributions for Roth 401(k)s, further increase the appeal of Roth contributions.
Lastly, when considering estate planning, the "10-year rule" introduced by the Secure Act of 2019 should not be overlooked. For new business owners who wish to pass on their retirement savings to non-spouse beneficiaries, Roth IRAs can be particularly advantageous. Non-spouse beneficiaries can withdraw funds tax-free, thereby minimizing the tax implications of the inherited IRA.
When starting a new business, consulting with a financial planner is essential to make informed decisions about pretax and Roth contributions to a 401(k) plan. Considering individual circumstances and goals will ensure that new business owners maximize the benefits of their retirement savings while minimizing their tax liabilities.
Article First Published at: https://www.cnbc.com/2023/07/10/pre-tax-vs-roth-401k-how-to-decide-which-option-is-best.html