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401k’s are great savings vehicles for employees and have additional tax advantages if properly utilized.
401K • TAX ADVANTAGES • IMPACT INVESTING
Most employers usually offer both pre-tax and Roth after-tax accounts. The difference between these is noted below:
When deciding if a pre-tax or Roth 401k is right for you it is key to predict what you think your tax rate may be in retirement compared to your current tax rate. In most cases, in your early years of working, your tax rate will be low so utilizing a Roth 401k is usually the best option. Additionally, with tax rates reaching historic lows and US debt levels increasing at an unsustainable pace, it is likely that taxes will be significantly higher in the future. This is another compelling reason to lean toward utilizing the Roth 401k.
Other 401K Considerations
Pre-tax contributions could be better if:
Roth after-tax could be better:
If you are under 50, you can contribute up to the 2022 IRS limit of $20,000 (this is a total of both pre-tax and Roth contributions and does not incorporate what the company may match or contribute to your 401k). If you are 50 or older, you can make an additional contribution of $6,500 for a total of $26,500.
Qualified Distribution (Roth 401k Only)
Two requirements for a qualified distribution:
There are a lot of flexibility with these plans and you can split your contributions between the pre and post-tax contributions and change these allocations over time.
One of the key considerations in thinking about pre or post tax accounts is how much time until you expect to retire.
5-10 Years to Retirement
10-20 Years to Retirement
20+ Years to Retirement
Tax diversification can help over time and provide the ability to save on taxes and grow assets when taxes may be higher because of higher income.
Back-door Roth Conversions
Roth conversions allow you to convert a portion or all of your pre-tax account to Roth after-tax dollars. You can do this in multiple phases to spread the tax burden over a number of years, lessening a dramatic tax hit and allowing for the possibility of converting in a year where you have less earnings.
Note: For tax-free treatment on money converted, you have to be at least 59 1/2 for withdrawal and it has to be five years since the earliest of the first conversion or first Roth contribution.
With tax rates reaching historic lows and US debt levels increasing at an unsustainable pace, it is likely that taxes will be significantly higher in the future. This is another compelling reason to lean toward utilizing the Roth 401k.
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