Many people view a Roth IRA as the end-all-be-all solution to retirement savings. Then, when their income grows, and they phase out of being able to contribute to a Roth IRA, they’re left feeling lost and frustrated.
How in the world am I supposed to save for retirement in a tax-efficient way now?
The good news is that you can still save for retirement and mitigate the impact of taxes on both your savings and your current income. You have a wide range of options, but I want to cover two big ones here:
- Using a Roth 401(k).
- Rolling over your 401(k) to a Roth IRA.
Ready? Let’s dive in.
Roth 401(k) Option
A Roth 401(k) marries elements of a traditional 401(k) and a Roth IRA. As is the case with a traditional 401(k), there are no income limitations, and you have a higher contribution limit ($19,000 in 2019, plus an additional $6,000 if you’re age 50 or older). However, like a Roth IRA, all contributions are after-tax, which means that you’re able to make qualified withdrawals from the account during retirement tax-free.
Many people flock to the Roth 401(k) for this reason. It feels like a best-of-both-worlds type of solution. In some ways, it is. There are a lot of positive benefits to funneling money into a Roth 401(k). However, if you’re contributing to a Roth 401(k) through your employer, it has the potential to hit your cash flow in a big way. Because contributions are after-tax, you’ll be seeing less money in your paycheck (because more of it will go to the IRS for taxes), and you’ll still be contributing to the account on top of that which lowers your paycheck even more. If your budget can withstand this type of hit, the Roth 401(k) can have a lot of benefits and tax-efficient withdrawal strategies during retirement.
Regular 401(k) Option + Roll-Over
Did you know that many employers allow you to make after-tax contributions to your 401(k)? This is the other way that people can potentially circumvent the Roth IRA phase-out income range without contributing to a Roth 401(k).
The 2019 contribution limit to a 401(k) is $19,000 of pre-tax funds. However, the total “cap” is $56,000. This includes pre-tax contributions, salary deferrals, employer contributions, and after-tax contributions. That’s right – you could potentially contribute tens of thousands of dollars more to your traditional workplace 401(k) after-tax.
When you retire or choose to roll over your 401(k) after a job change, you can choose for the funds to be rolled over to multiple locations. For example, your pre-tax funds in a 401(k) may be best served in a Traditional IRA to keep growing pre-tax. However, your after-tax contributions to a 401(k) can be rolled over to a Roth IRA – which you can then take qualified withdrawals from tax-free during retirement. In this way, using a one-time rollover of your 401(k), you can still contribute to a Roth IRA even if your salary technically bars you from opening and contributing to one on your own.
According to the IRS, you can also opt to dissect your 401(k) even further during the rollover process. You have the option to roll your pre-tax contributions to a Traditional IRA, the earnings on your after-tax contributions to the same Traditional IRA, and your after-tax contributions (principal-only) to a Roth IRA. This can help to save you even more in capital gains tax during the rollover if that’s your goal.
Keep Funding Your 401(k) With Pre-Tax Contributions
Remember: just because Roth-style accounts have benefits during retirement doesn’t mean you shouldn’t still contribute pre-tax funds to your 401(k). By doing so, you’re able to continue to receive the tax deduction now for contributing to a 401(k) plan. You’re also offering yourself an additional way to build a retirement income strategy during retirement. Diversifying your tax strategy isn’t a bad idea – and it can benefit you both now when you go to file your taxes, and during retirement when you’re looking to mitigate the impact of taxes on your distributions.
The Bottom Line: You Have Options
There are several different ways to save for retirement and reduce the impact that taxes have on your wealth. The key is to have a strategy that leverages savings tools in a way that works best for your unique goals – both now and in the future. Do you want to talk about your retirement savings goals? Schedule a consultation with me today. I’d love to help you go over your strategy and build a unique plan that puts you on the path toward a fulfilling (and tax-efficient) retirement.