Tax Planning and the New Year
April 15 isn’t the only time that your taxes are important. With a new year upon us, now is another crucial time to discuss financial planning and taxes, and how the two work together.
For example, if your employer offers a 401(k) retirement plan, its tax-saving benefit can be a great asset. Whether you choose a traditional pre-tax 401(k) or a Roth after-tax 401(k), being able to protect your investments from annual taxes is a huge benefit.
Not only that, but the Internal Revenue Service raised the aggregate annual maximum contribution for 401(k)s for 2020. It is now $19,500,up from $19,000 in 2019. Plus, if you’re 50 or older, you can save an additional $6,500 (up from $6,000 in 2019). That means you may be able to sock away a total of $26,000 this year. This is far more than the Individual Retirement Account (IRA) maximum of $6,000 ($7,000 if you’re 50 and older).
Roughly half of employers who offer 401(k)s offer both traditional and Roth plans. Let’s briefly review the tax advantages of both, and then discuss why one may be more advantageous for you.
Tax Benefits of a Traditional 401(k)
In a traditional 401(k), your contributions are taken out pre-tax. This lowers your taxable income for the year, and it can lower your overall tax rate.
The money in your 401(k) account(s) grows tax-deferred until you retire.
Then, when you retire, you can begin withdrawing money from your 401(k). At that point, the withdrawals are taxed. You can begin taking withdrawals penalty-free when you are 59-½, and you must take Required Minimum Distributions (RMDs) beginning at 72.
Tax Benefits of a Roth 401(k)
Contributions to a Roth 401(k), by contrast, are made with money that’s already been taxed in the year the contribution was made. There is, therefore, no immediate effect on your taxes in the year of contribution. However, you’ll see the tax advantages to a Roth 401(k) at retirement. The contributions you withdraw at that point are not taxed at all, unlike the traditional 401(k) contributions, as long as you have held them for at least five years.
Like traditional 401(k)s, Roth 401(k) account money grows tax-deferred until you withdraw it in retirement.
Making a Decision: Taxes and Plans
Choosing the best 401(k) type for you really boils down to two interrelated questions:
- Will it be more advantageous to pay taxes on your funds once you retire, or in the year of contribution?
- What’s your tax rate now versus your likely tax rate at retirement?
The answer depends on several factors.
First, your current age may very much matter in this decision. If you are currently middle-aged and at or near peak earnings capacity, saving money pre-tax in a traditional 401(k) will lower your taxable income for the year and may lower your tax rate. This is particularly beneficial if you’re in a high tax bracket. When you retire, your income will likely be lower, so you may be in a lower tax bracket. The traditional 401(k) withdrawals will thus likely be taxed at a lower rate.
If you’re younger, on the other hand, and earning less than you may be at retirement, it might benefit you to use after-tax income in a Roth 401(k) now, so you can withdraw the money in retirement tax-free. In other words, if you expect your tax rate to be higher in retirement than it is now, you will be paying taxes now, at a lower rate than you would be in the future.
Your decision should also depend on the tax flexibility you think would be most advantageous in retirement. If you have both traditional (taxed at withdrawal) and Roth (not taxed at withdrawal) assets to pull income from in retirement, you would have the flexibility to choose how much from each bucket will make up your income.
Working with a financial advisor who specializes in 401(k) planning can be extremely beneficial in helping you make the best decision for your situation. As you can see, a mistake can result in losing potential money.
When you and your advisor calculate your retirement income needs, be sure to include calculations for savings in retirement, too. You might want, for example, to fund travel plans or have a nest egg for unexpected financial emergencies, such as sudden and high medical expenses. Given that medical expenses later in life tend to be much greater than they are when you’re younger, a nest egg could give you peace of mind. Bear in mind that healthcare costs have been climbing steeply over the past several decades, and that shows no sign of abating.
Planning for Your Goals and Needs
Bear in mind that you can invest in both types of 401(k)s. While it’s important to know the relative advantages of each, you can definitely choose to earmark a certain percentage of your retirement funds to traditional 401(k) accounts and a certain percentage to Roth 401(k)s.
Splitting your retirement funds between the two types may increase your chances of maximizing the tax advantages of each.
Why? Well, it can be challenging, of course, to try to forecast what your taxable income and tax rate will be years into the future, particularly if you’re young, and that makes choosing between a traditional and Roth 401(k) difficult. Even if you’re closer to retirement right now, your estimate has no guarantee of being correct.
In addition, tax rates may vary through the years. Right now, taxes are at a historically low level. But there’s no telling what might happen in the future. U.S. tax rates are subject to many forces, including national and statehouse politics and perceptions of the tax coffers versus public spending.
To make sure your decision maximizes your tax benefits, it’s a good idea to discuss the allocation between the two different types with a financial advisor. Financial planning and taxes should go hand-in-hand. Contact Scarborough Capital Management to see how we can help.
This is not, and you should not consider it to be, legal or tax advice. The tax rules are complicated and their impact on a particular individual may differ depending on the individual’s specific circumstances. Neither IFG, nor SCM, provide tax or legal advice. Please consult with your legal or tax advisor regarding your specific situation.