Use a Roth 401(k) to Boost Retirement Savings
There’s a Case for a Roth to Boost Retirement Savings as New 401(k) Options Emerge.
Many companies are starting to offer employees the choice of Roth 401(k)s as well as traditional 401(k)s to boost retirement savings. Both are tax-favored accounts. A traditional 401(k) invests pretax money and is taxed upon withdrawal, while the Roth 401(k) invests post-tax money and is not taxed upon withdrawal. Which is a better way to invest?
Retirement Accounts and Tax Rates
If tax rates are constant, then a traditional 401(k) is technically the same as a Roth IRA. That is, it does not matter whether the account is taxed at the beginning or the end. Since tax is deferred in a traditional account, more money is invested and the total earnings are greater than in a Roth account. However, when taxes are paid upon withdrawal, it turns out that the tax on the extra earnings is exactly equal to the lost earnings from the tax paid in the Roth account. The taxes and extra earnings cancel each other out, leaving the Roth and traditional accounts with the same amount of after-tax money.
This does not, however, mean that Roth and traditional accounts are equivalent. We assumed above that taxes are constant and that the investor can save the same amount of money in either type of account. However, not only is the individual likely to face a different tax rate upon retirement than when earning the money, but also, it turns out that more money can implicitly be saved in a Roth account than a traditional account.
The change in tax rates is straightforward. If you expect the government to raise tax rates, then a Roth 401(k) would be the better investment vehicle because you would be paying less tax at the lower, earlier rate. On the other hand, if you expect to drop to a lower tax bracket upon retirement, then a traditional 401(k) is the better way to go. [See: Tips to Ensure Your Retirement Income]
What is less commonly understood is that a Roth account allows you to save more money in a tax-preferred manner. In 2013, the maximum contribution to a 401(k) is $17,500. This is the same whether you use pre-tax dollars for a traditional 401(k) or post-tax dollars for a Roth 401(k). However, tax has already been paid on the Roth account. Implicitly, this means you are saving more money in a tax-deferred manner using a Roth than a traditional once you approach the investment limits. Each account may start out with $17,500, but once money is withdrawn, the traditional account will be taxed, meaning it has less money.
As always, the optimal strategy will vary from individual to individual and is very dependent upon their expectations for the future. One possible strategy to boost retirement savings would be to combine traditional and Roth 401ks. Having both creates a hedge, allowing the individual to prepare for either rising or falling tax rates. Mixing in some Roth with the traditional account will also serve to lower the retirement tax rate. In this case, it generally is best to invest in the Roth in early years and traditional 401(k) later to save for a comfortable retirement. There are two reasons for doing so. First, the individual’s tax is almost certain to be lower in early earning years. Secondly, it is best for those early investments, which will experience the greatest compound growth, to grow in a retirement account and minimize the capital gains tax.
In the end, the most important decision is to invest. Whether you use a Roth, a traditional 401(k) or both, it is important to make that commitment early on and to maximize your investment.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly. This is a hypothetical example and is not representative of any specific situation. Actual results will vary.
Read this article on U.S. News & World Report…
What’s Next:
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Monument Capital Management, LLC [“Monument”]), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Monument. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. No amount of prior experience or success should be construed that a certain level of results or satisfaction will be achieved if Monument is engaged, or continues to be engaged, to provide investment advisory services. Monument is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.
A copy of Monument’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or at www.monumentwealthmanagement.com/disclosures. Please Note: Monument does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Monument’s website or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your Monument account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your Monument accounts; and, (3) a description of each comparative benchmark/index is available upon request.
Please Remember: If you are a Monument client, please contact Monument, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Please Also Remember to advise us if you have not been receiving account statements (at least quarterly) from the account custodian.