Making after-tax contributions, also known as Roth contributions, to your 401k or IRA can be an effective way to save for retirement and lower your future tax bill. Unfortunately, lowering your future tax bill often means increasing your current tax bill, making the pre-tax vs after-tax decision difficult. This week I would like to propose a creative solution for those 40 and over – why not contribute to both! Here is a way to make the most of both the traditional and Roth retirement plan contribution limits.
Let’s begin with a review of the basics. Traditional retirement plans were designed for pre-tax earnings contributions that provided for tax-deferred growth. Traditionally, employees made retirement plan contributions pre-tax, the contributions grew tax-deferred, and then the distributions from the retirement plan were taxed over many years during retirement. Roth contributions changed the equation, allowing for after-tax contributions, that grow tax-free, and then are not taxed when distributed during retirement. In a simplistic sense, the pre-tax vs after-tax decision can be summed up as “Pay taxes now or pay taxes later”.
Much has been written about which is better, pre-tax or after-tax. Here is our Retirement Savings Game Plan for more details on a strategy based on your age. "Retirement or Roth: Tax Savings Game Plan." In general, those under 40 are generally better off using Roth retirement savings, and those in their 40’s and 50’s, typically in their peak earnings years, are generally better off using traditional retirement savings. But here is a radical idea. If you are in your peak earnings years, why not contribute to both traditional and Roth accounts to maximize your retirement deduction and savings.
The ‘both’ strategy begins with maximizing your 401k using traditional pre-tax contributions to your 401k. This step takes full advantage of the 401k retirement savings tax break. Remember, a 50-year old can contribute $26,000 per year to a 401k, providing a top earner in the 40% tax bracket more than $10,000 in tax savings. The next step is to contribute some of those savings, up to the $7,000 maximum, to a Roth IRA, usually using the back-door Roth "Tax Tip: The Backdoor Roth IRA." This combined strategy results in the maximum tax savings from traditional 401k contributions, and the maximum tax-free savings from the Roth IRA. It is the best of both worlds!
During retirement having a mixture of savings, both pre-tax and post-tax, helps reduce taxes once again. Retirees can draw retirement funds from either the pre-tax or post-tax buckets to stay in the lower tax brackets.
If you have been trying to decide between traditional or Roth retirement plan contributions, consider making the most of both options and contributing to both. Need some help? Please give us a call and we would be happy to help analyze your situation.
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