A Roth 401(k) May Become a More Popular Choice For The Highest Earning Taxpayers

Tax rates seem likely to rise for the wealthiest and highest-earning taxpayers under the Biden administration. For those with traditional retirement accounts, who are in a high tax bracket, making moves ahead of tax law changes can reduce income-tax bills in retirement given tax changes occur. IRA and 401k investors should consider the advantages of diversifying retirement funds among an IRA and a Roth IRA, and 401(k) assets between a Roth 401(k) and Traditional 401(k).

The key strategy to pursue is the Roth conversion. These allow account owners to transfer some or all the money in a tax-deferred IRA or 401(k) to a Roth account, in which you contribute after-tax dollars and get tax-free withdrawals. For workers with the option, it can also make sense to funnel future retirement account contributions into a Roth 401(k).

Although you will have to pay income tax on the transfer, thanks to the tax cuts enacted in 2017, many high earners stand to pay a lower tax rate today than they would by deferring the payments until retirement. Tax rates today may be the lowest you will see for the rest of your life. For people with big retirement account balances, it can make sense to pay tax today to lock in current rates and eliminate the risk of higher rates in the future.

Under the Biden proposal, the administration would raise the top income-tax rate to 39.6% from 37%. Currently, that applies to taxable income above $523,600 for individuals and $628,300 for married couples.

With a traditional IRA or 401(k), individuals generally get to subtract contributions from their income and reduce the taxes they pay. Amounts in the account grow tax-free, but owners must pay ordinary income tax on the money when they withdraw it in retirement.

Why bother converting? Once you hold a Roth for at least five years and are age 59½ or older, future withdrawals of both principal and appreciation are tax- and penalty-free.

In retirement, people with Roth accounts can take tax-free withdrawals to supplement their taxable income and stay within a lower tax bracket. Some may be able to use Roth withdrawals to reduce or avoid the surcharges on Medicare premiums that kick in above $88,000 in income for individuals and $176,000 for couples.

Another advantage to a Roth is you will not ever have to take a required distribution.

The biggest difference between a Roth 401(k) and a traditional 401(k) is how and when you get a tax break. Contributions to traditional 401(k) are made without any taxes withdrawn (before tax), but withdrawals in retirement are taxable at your ordinary income tax rate. Whereas contributions to Roth 401(k) are made after taxes, but the withdrawals in retirement are tax-free.

Thus, most advice on the Roth 401(k) vs. traditional 401(k) topic depends on the following questions. First, are tax free withdrawals more important to you in retirement after your account has grown? On the other hand, is the before tax contribution more important to you now? Without question the before tax contribution helps lower your taxable income by the amount of your contribution resulting in meaningful income tax savings. It is the way to contribute for most plan participants because your contribution is subsidized by the Federal government by the amount you save on taxes by lowering your income tax.

Even so, the income benefit of withdrawing retirement funds that have grown by up to millions of dollars tax free, savings hundreds of thousands in dollars in income taxes in retirement, cannot be ignored. If you do not need the income tax deduction a traditional 401(k) offers, you may want to explore with your tax adviser or Investment Adviser the benefits of contributing to a Roth 401(k). Your plan allows you to contribute to both your traditional 401(k) and Roth 401(k).