Putting money aside for retirement in your firm’s 401k plan is a great decision, and some firms give you a choice – save in a traditional 401k or a Roth 401k.
Most people know how a traditional 401k works. Your retirement dollars grow tax-deferred on income that you contribute, and you pay taxes when you withdraw your money in retirement. Unless you are still working, participating in the firm’s retirement plan or own greater than 5% of the company, Uncle Sam wants his money. You must make Required Minimum Distributions (RMDs) starting at age 70 ½.
The problem is that many high earning attorneys, or those on their way, will likely be in the top tax bracket even after retirement when they consider any pensions, investment income or other income accumulated along the way. That means any deferred income put into a traditional 401k will be taxed at the highest rates.
The annual 2015 contribution limit for the Roth 401k is the same as the traditional 401k – $18,000 plus up to an additional $6,000 for those over age 50, and the investment options are the same for both. The similarities end there.
The Roth 401k has a few distinct advantages over a traditional 401k for high earning partners:
- There is no income limit to making Roth 401k contributions unlike Roth IRAs which are phased out at higher income levels. Partners are generally phased out of Roth IRA contributions because of their income.
- While the deferred income is taxed before going into the Roth 401k, the growth on that money is tax free.
- Roth 401ks can be rolled into Roth IRAs upon retirement or leaving the firm.
- Best of all, since there are no required distributions from Roth IRAs upon reaching age 70 1/2, there are more opportunities for planning.
For instance, partners may want to consider the benefits of asset location when reviewing their portfolio allocation. One tactic is to place more aggressive assets within the Roth because these will be the last dollars they should tap in retirement. Individuals can use the long time horizon of the Roth 401k to their advantage and withstand the added risk in this account. To understand how this works, I recommend that you read: The Best Way to Minimize Taxes With Asset Location.
Not every firm offers a Roth 401k option, and if your firm does, you have a unique opportunity to diversify your future retirement income. It could play an important part in helping to reduce your future taxes and provide planning options for your family.