Listen to John Woolley, CEPA , Managing Director of Wealth Management and Chief Investment Officer, and Lauren Reed, CFP®, Director of Wealth Planning, discuss the various types of Roth investments.
You have probably been hearing a lot more recently about Roth IRAs and 401(k)s and you might be asking yourself, “What’s the big deal with Roth? What is a Roth?” A Roth IRA was created in 1997 through the Taxpayer Relief Act by Senator William Roth from Delaware to enhance retirement saving options. Saving in a Roth investment vehicle can be a powerful financial tool, and there are many ways to contribute to one. First, let’s talk about the difference between a Traditional 401(k) and Roth 401(k).
The key difference between the two is when taxation occurs. When you contribute to a Traditional 401(k), you reduce your taxable income in that year. Later, when you make withdrawals from the account in retirement, you pay income taxes on the amount you take out. However, when you contribute to a Roth 401(k), you do not receive a tax deduction in the current year, but the withdrawals in retirement are tax-free. If you feel that you are going to be in a higher tax bracket in the future, you might want to explore the Roth option, which provides tax-free distributions at your discretion. Generally, if your goal is to shield yourself from income taxes now, you may want to go with the Traditional 401(k) or IRA contribution.
Contributing to a Roth 401(k) vs. a Roth IRA
From a tax standpoint, the two accounts are effectively the same, but from a contribution standpoint there is a big difference. For the 2023 tax year, if you make above $153,000 as a single filer (or $218,000 as a joint filer) you cannot contribute to a Roth IRA. A Roth 401(k), however, does not have this limitation, which makes it a great savings tool for all income levels. Through the recently passed Secure 2.0 Act, you can now elect to have your employer match go directly into your Roth 401(k). Previously, all matching dollars had to go into your pre-tax account.
If your employer does not offer a Roth 401(k) and your income is above the limits, you can still contribute to a Roth IRA via a Roth conversion. A Roth conversion is the process of taking money from an IRA or a Traditional 401(k) and moving it into a Roth IRA. Remember, though, when you convert funds from a Traditional 401(k) to a Roth IRA, the amount converted counts as income to you in the year you make the conversion, increasing your taxable income for that year.
Required Minimum Distributions
Another big advantage of the Roth is that there are no required minimum distributions during retirement. In a Traditional IRA or 401(k), the IRS requires minimum distributions during retirement and collects taxes on those distributions. In a Roth IRA or 401(k), you are contributing dollars that have already been taxed by the IRS, so they do not require you to take distributions in retirement. Since you are not required to take any distributions, the dollars left in a Roth can be transferred to your chosen beneficiaries or to your favorite charity, making the Roth a powerful estate planning tool.
This covers just a few key factors of Roths, but we have only scratched the surface. There are Roth IRAs that can be established for children, “backdoor” Roth conversions, first-time home buyer distribution penalty exemptions – the list goes on and on. If you would like to discuss your specific situation, please reach out to us at email@example.com
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