Most companies offer traditional 401(k) accounts to employees. In these accounts, employees make pre-tax contributions (up to $18,500 in 2018) to save for retirement and reduce current taxable income. When funds are withdrawn (not rolled over) from the 401(k), the entire withdrawal is taxed at the taxpayer’s current tax rate. Hence, if you are in a high tax bracket now and expect to be in a lower one when you retire, the traditional 401(k) is a great option to pay a lower tax rate in the future on today’s earnings.
Recently, some companies have begun to offer a Roth 401(k) option. Contributions to a Roth 401(k) are made with after-tax dollars, hence there is no reduction in current taxable income. The contributions and earnings can then be withdrawn tax-free after you reach 59 1/2 and as long as the Roth 401(k) has existed for at least 5 years. If the contributions are withdrawn before 59 1/2, earnings (not contributions) are taxed and there is a 10% penalty. Hence, a Roth 401(k) is a great option if you are in a low tax bracket currently and expect to be in a higher one when you retire.
The type of 401(k) you should contribute to really boils down to your current tax bracket and your expectations about future taxes (i.e., in retirement). If you are currently in one of the top tax brackets (> 30% federal and > 10% state), then it usually makes sense to use the traditional 401(k). This provides a tax reduction equal to your combined federal and state marginal tax rate for the current tax year (potentially > $0.50 for each $1 contributed if you are in the top federal and state tax brackets). If you are in a low tax bracket (<20% combined), then a Roth 401(k) usually make more sense as your taxes are likely to be higher in the future. If you are somewhere in between, you could consider splitting your contribution (if the company permits it). The maximum combined employee contribution to a traditional 401(k) and a Roth 401(k) is $18,500 in 2018.
One thing everyone should take advantage of is their company matching on 401(k) contributions. Since this is essentially “free” money, it usually makes sense to contribute enough (usually 4-5% of salary) to the 401(k) in order to get the full company match. It should be noted that any matching contributions from your company will go into a traditional 401(k) even if you are making only Roth 401(k) contributions.
There are more complex rules related to rollovers of Roth 401(k)s to Roth IRAs that could make some amount of Roth 401(k) contributions advantageous even for high tax bracket earners. If you are uncertain about your investments, a financial advisor can help you with the many factors and decisions involved with investing. Feel free to contact us with any questions at info@L2Wealth.com.
Disclosures
All written content on this site is for information purposes only and should not be considered investment advice. Opinions expressed herein are solely those of L Squared Wealth Management LLC unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another party’s informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant, or legal counsel prior to implementation.
Advisory services are offered through L Squared Wealth Management LLC, a California registered investment advisor firm. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by our firm in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. Advice may only be provided after entering into an advisory agreement with L Squared Wealth Management LLC.
Past performance is no guarantee of future results.
