Many of our clients ask us about the benefits of a Roth IRA vs a 401(k) – or wish they could be contributing more to a Roth than they are currently eligible for. No one has ever complained about having too much money in their retirement accounts – but from the tax reduction perspective – which is better?
From a tax planning perspective, a 401(k) (or equivalent) is something that we call a tax deferment vehicle – you WILL pay taxes on funds in your 401(k) – just not now. You will be required to start taking distributions at the age of 72. Depending on your age, that may be fairly far into the future.
No one can predict what the tax rate will be when you turn 72. Although it does not feel that way, tax rates today are relatively low – they reached as high as 93% during World War II! – and are predicted to increase in the near future as a result of the current economic crisis.
That is the risk we are taking with 401(k) contributions – the tax rate upon our retirement may be much higher than it is now, and a large portion of our funds may go straight to the IRS, leaving us at a disadvantage from the tax planning perspective. If you have $1,000,000 in your 401K – that amount might get cut in half by the IRS by the time you are 72!
What about Roth IRAs?
Roth-IRA contributions are made in post-tax dollars, and distributions upon retirement will NOT be taxed. Here we are taking the bet that tax rates WILL increase, resulting in tax savings upon retirement.
All the money in a Roth IRA (including any earnings on your contributions) is yours – however, most of our clients cannot contribute directly to a Roth due to high income, and doing a backdoor Roth is not always possible.
There are solutions to this – including Private Deferred Compensation Plans that do not need to follow ERISA rules (that is the Employee Retirement Income Security Act, which sets standards regarding most retirement plans).
Which is better?
We love to see our clients have both a 401K (or equivalent) AND a Roth IRA (or a Roth IRA lookalike for those earning too much or unable to contribute to a Roth). This way you are at an advantage despite the tax rate when you reach retirement age.
Have questions about retirement, Roth IRA lookalikes, or tax planning? We’re happy to help.
Schedule a consultation to find out more!