Building Your Wealth Inside Corporate America
Financial Strategies for Today's Executive
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Pre-tax or Roth 401(k)?
Most 401(k) plans offer two types of accounts; a pre-tax (or before-tax) 401(k) and a Roth 401(k). The difference is whether you receive a tax deduction on your contributions, and how the money is taxed when it’s withdrawn in retirement. For most executives, it makes sense to put your money into the pre-tax 401(k) to receive the tax deduction—one of the very few ways to save taxes each year. For example, your taxable income is $300,000 annually. A 401(k) deposit of $19,500 will save about $6,000 in income tax assuming your average annual federal and state tax rate combined is 30 percent. In retirement, when you withdraw money from your 401(k), you’ll pay tax at that time and at your then current tax bracket, which is presumably lower than in your working years.
On the other hand, a Roth 401(k) can be the better choice for young executives who are just starting their careers and earning less than approximately $150,000, because they are in a lower tax bracket. Withdrawals from Roth 401(k) plans are tax-free in retirement (after age fifty-nine and a half ) based on current tax law. Or, if you believe your tax rate will be higher in retirement (expecting a huge inheritance? moving to a higher tax rate state?), funding a Roth 401(k) and foregoing the tax deduction now may make sense.
A limited number of 401(k) plans offer a third type of account for which you can put money into, which is called an after-tax account. It is different than a Roth 401(k). Here, you can put money into the after-tax account on an after-tax basis like the Roth 401(k), the earnings grow tax-deferred like the pre-tax 401(k) and the Roth 401(k), and when you take withdrawals or rollover the after-tax account to an IRA at retirement, a portion of the withdrawal will be tax-free. If your employer offers this type of account within the 401(k) plan, it may be wise to put some money into it after maximum funding your pre-tax 401(k) account. Some 401(k) plans allow you to convert your after-tax account balance to a Roth 401(k) periodically throughout the year, which can be a good long-term tax move, but you may pay a small amount of tax each year on the portion of the conversion that equals earnings. Or when you leave your employer, you can rollover the after-tax contributions in the after-tax account to a Roth IRA and roll the earnings portion of the after-tax account (the part that’s not yet been taxed) to a traditional IRA. Both of these rollovers will result in zero dollars in tax if handled properly.