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401K • TAX ADVANTAGES • IMPACT INVESTING
Most employers offer both traditional and Roth 401k accounts. Here’s the core difference:
Traditional (Pre-Tax) Contributions: These contributions are deducted before income taxes are calculated, which reduces your current tax liability. However, when you withdraw the funds in retirement, you’ll have to pay taxes on both the contributions and the earnings.
Roth (After-Tax) Contributions: These contributions are deducted after income taxes have been calculated, meaning they don’t lower your present tax bill. But the real benefit comes during retirement, when you can withdraw the funds entirely tax-free.
Choosing between a traditional or Roth 401k depends largely on your expectations about your future tax rate compared to your current tax rate.
Making the right choice between traditional or Roth 401k contributions is, in large part, a strategic game of predicting your future tax situation. It’s about looking into your financial crystal ball and making the best educated guess about what your tax landscape will look like when you retire, compared to where it stands now.
Consider this scenario: If you’re in the early years of your career, chances are your income bracket is relatively modest, and consequently, so is your tax rate. In this situation, choosing a Roth 401k often makes more sense. Your contributions will be taxed at your current lower rate, and then, you can enjoy those retirement distributions tax-free, regardless of whether tax rates have skyrocketed in the interim.
Furthermore, it’s essential to take into account the economic climate and trends. Currently, we’re experiencing historically low tax rates. But with rising national debt, it’s reasonable to foresee a future where tax rates could be significantly higher. If such a scenario materializes, those who chose to lock in their tax rate today with Roth contributions could find themselves with a significant advantage.
Ultimately, it’s about using the information available to you now to make the most informed decision possible for your future financial health. That said, predicting future tax rates is certainly a challenge and, while it’s an important consideration, it shouldn’t be the only factor guiding your 401k strategy.
Traditional Contributions Could be Better If:
Roth After-Tax Might be Better:
As of 2022, if you’re under 50, you can contribute up to $20,000 in total to both traditional and Roth 401k accounts (excluding any company match). If you’re 50 or older, you can make an additional catch-up contribution of $6,500, for a grand total of $26,500.
When it comes to the world of Roth 401ks, there’s a particular term that you’ll frequently encounter: ‘Qualified Distributions’. But what exactly does this mean?
A ‘qualified distribution’ from a Roth 401k is one that is both tax-free and penalty-free. However, this advantageous treatment isn’t handed out freely. There are two key conditions that must be met before you can enjoy a qualified distribution:
It’s a nuanced part of the Roth 401k landscape, but understanding these criteria can help ensure you’re optimizing your tax-free benefits.
A key factor in deciding between pre or post-tax accounts is the time until you expect to retire.
5-10 Years to Retirement:
10-20 Years to Retirement:
20+ Years to Retirement:
A Roth conversion lets you convert all or part of your traditional 401k to a Roth 401k. You can spread this conversion over several years to manage the tax impact and potentially convert in a year with lower earnings.
Please note, for a tax-free treatment on converted funds, you need to meet the following conditions:
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