In the world of retirement planning, the 401(k) has long been a popular vehicle for saving. SECURE Act 2.0 provides added Roth 401(k) advantages, allowing matching and other employer contributions. Now is a good time to reevaluate what types of contributions are best for you.
Benefits of Participating in a 401(k) Plan
Employer Match: Many employers offer to match your contributions; this is essentially free money, boosting your savings significantly.
Compound Growth: Over time, consistent contributions can lead to substantial growth, thanks to the power of compound interest.
Diversification: 401(k) plans often offer a variety of investment options, allowing for diversification of your retirement portfolio.
Convenience: With automatic contributions, 401(k)s simplify the saving process, making it easier to stay consistent.
Traditional 401(k) Contributions
The most significant perk for making traditional 401(k) contributions is the current tax advantage. Contributions are made pre-tax, which can lower your taxable income now. This is especially powerful for high-income earners.
Roth 401(k) Contributions
Roth contributions are made after tax, which means that you forgo the current tax deduction in exchange for the balance to grow tax-free for life.
Factors to Consider
Current vs. Future Tax Rates: You might expect your tax bracket to be lower in retirement when you are no longer collecting a paycheck. Your future tax bracket will be determined by your income and the future tax brackets for that income. Determining the type of contribution that works best for you includes forecasting those future tax bracket rates.
Other Retirement Income Sources: It is important to consider all your future income streams. Social security, pensions, and annuities will generally add to your taxable income. Will you have other taxable income from real estate or a family business interest?
Taxation to Beneficiaries: If you plan on leaving your retirement plan assets to non-spouse beneficiaries, the new rule requires them to fully distribute the balance over 10 years. Withdrawals from an inherited 401(k) may come during a beneficiary's highest earning years.
The choice between traditional and Roth 401(k) contributions is highly dependent on your individual situation. You must balance the certainty of current income and tax rates with the uncertainty of future rates. Consider diversifying your savings into traditional pre-tax contributions and after-tax Roth contributions, including your 401(k) and self-directed IRA accounts.