Retirement planning involves balancing what you’ll save now, alongside what you’ll pay in taxes in the future while in retirement. Thus, it makes perfect sense to split your retirement savings between a traditional 401(k) and a Roth 401(k) or IRA.
With a traditional 401(k), you make pre-tax contributions and pay taxes when you withdraw in retirement.
However, contributions to a Roth 401(k) are already taxed, so it will be tax-free when withdrawn in retirement if you’ve held it for at least five years.
While most people may not have an employer-sponsored 401(k) or a Roth account, you can still split your retirement savings on your own between a traditional 401(k) and Roth IRA. The decision between both choices all boils down to the taxes. There’s massive uncertainty about what may happen to charges in the years between now and your retirement. The decision is whether you should pay your taxes now or wait till after retirement.
Traditional 401(k) vs. Roth 401(k) — or both?
For most young people, the expectation is that as they grow into their careers, their income will increase, and they will be subject to higher taxes. The best plan is to put your money into a Roth account and grow a tax-free contribution.
Roth is also ideal for those in their 40s, 50s, and 60s. Even though they don’t have much time left, they can put as little as possible into Roth and withdraw the earnings tax-free if they still have five years before retirement.
However, if you are scrimping to save for your retirement, and the tax burden of going all Roth is too huge, then splitting your contributions between traditional and Roth will be a good plan.
Benefits of tax diversification
In addition to shifting your tax-load and giving you flexibility when withdrawing in retirement, diversifying between Roth and traditional has other advantages.
Firstly, it provides room to maneuver. Since you don’t need to take required minimum contributions on Roth IRAs until the owner’s death, you may want to roll both plans over to Roth IRA, as you draw closer to retirement. Alternatively, you can roll the Roth 401(k) into Roth IRA and traditional 401(k) into a traditional IRA to keep some tax diversification.
Another way people are maximizing tax diversification is by using two funds to manage their marginal income tax bracket. They pull money out of the tax-deferred fund for several purposes, and anything beyond a specific amount they take from their Roth accounts to avoid moving up to the next income bracket.
