CONTRIBUTE TO 401(K) OR ROTH IRA?

One of the more common questions came up again this week from a referral… ”I contribute 10% to my 401(k) and my employer matches the first 4%. I also would like to contribute to a Roth IRA. Should I just contribute to one or the other?” continued on page 14

401(k)s and Roth IRAs each offer something worthwhile, but slightly different and having both in your retirementplanning might be better than having just one.

Among the many advantages 401(k)s offer is that they make saving for retirement easy. The money comes right out of your paycheck. You also get an immediate tax break in that the money you contribute isn’t taxed until you withdraw it, preferably during retirement. Most employers match funds, perhaps the first 4% of what you contribute. Finally, 401(k)s have relatively high contribution limits. Federal law allows you to contribute up to $22,500 in 2023, plus up to an additional $7,500 if you’re 50 or older.

That being said, a 401(k) clearly should be a cornerstone of your retirement planning.

On the other hand, a Roth IRA has some great features too. You don’t get a tax break upfront since you’re investing aftertax dollars, but you do get one at the end. You can withdraw your contributions and earnings tax-free provided you meet the withdrawal requirements.

The Roth IRA contributions limits are lower than those in a 401(k) – $6,500 this year, plus another $1,000 if you are 50 or older. Of course, you’ve got to meet the eligibility requirements (phased out at $153,000 Adjusted Gross Income if single: $228,000 AGI if filing married) to contribute. Conversion from an existing Traditional IRA is another idea.

But as attractive as these plans are individually, they work even better as a pair. With a 401(k), you’re avoiding tax on your contribution today, but paying tax on withdrawals in the future.

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That means a 401(k) works best if you think your tax rate is higher today than it will be in the future. You’re avoiding taxes at a higher rate and paying them at a lower one. The reverse is true of a Roth, where you’re paying tax on your contribution today and avoiding taxes in the future. Thus, a Roth is a better deal when you expect your taxes will be higher in the future since you’re paying the lower tax bill today instead of tomorrow’s higher one.

Many 401(k) plans are now offering a Roth 401(k) component. Certainly, investigate that option if it is available. And the more time you have for your assets to grow, the more advantageous a Roth becomes. Another reason is, unlike most qualified retirement plans, Roth IRAs do not have Required Minimum Distribution mandates (which kick in at age 73 this year).

We can never be certain whether our tax rate will be higher or lower in the future. Even if you expect that your income will be lower in retirement, you may also lose lots of deductions (mortgage interest, retirement-plan contributions) that could result in a higher rate.

But by putting money in both a 401(k) and a Roth IRA, you’re hedging your bets. Having different pots of money taxed different ways gives you more flexibility in managing your income in retirement. If, for example, withdrawals from a 401(k) combined with Social Security and other income are about to push you into a higher tax bracket in a given year, you can always dip into your Roth.

So how can you maximize the advantages of both these savings plans? Start by contributing enough to your 401(k) to get the full employer match. This will give you the biggest bang for your 401(k) bucks: the convenience of payroll deductions, the upfront tax break and your employer’s matching funds (free money).

Next, contribute as much as you can to a Roth IRA, up to the limit. By taking this step, you get the advantage of tax-free withdrawals down the road, plus you get the tax diversification.

If you still save more money after this, then funnel your additional savings into your 401(k) until you reach the contribution limit. You won’t be getting the bonus of an employer match, but you’ll still get the convenience of payroll deductions, plus your money will grow without the drag of taxes until you withdraw it.

In any case, that’s the strategy in a nutshell: do the 401(k) to the full match, then the Roth, back to the 401(k) and,

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ADDRESS: if you can save still more, look for good options in taxable accounts. If you do this on a regular basis, you should not only have a nice fat nest egg when you retire, you should also gain some decent maneuvering room for reducing the tax bite on withdrawals from that nest egg during retirement.

As always, talk to your financial professionals and tax advisors, to determine your specific needs and goals.

Scenarios illustrated are hypothetical in nature, results may vary. Investing is subject to risk which may involve loss of principal. Past performance is not indicative of future results.

The M3 Wealth Management Office does not provide legal or tax advice. Consult an attorney or tax professional regarding your specific situation. The information herein is general and educational in nature and should not be considered legal or tax advice. Trust services are provided by third parties. Neither our firm nor our financial professionals can serve as trustee

Michael J. Donnellan specializes in stock selection and retirement planning. Feel free to contact him with any questions or comments at the M3 Wealth Management Office at 17601 W. 130th Street – Suite 1 in North Royalton, Ohio.

Phone number (440) 652-6370 Email: donnellan@m3wealthmanagement.com

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