Should you make 401(k) or Roth IRA contributions?

In a perfect world, the answer would be both. If you have the means, maximizing your traditional 401(k) and Roth contributions is a great way to build a diversified set of retirement savings. But, of course, your paycheck gets a vote. So, if you have to choose, should you switch from contributing to a 401(k) to Roth 401(k) or Roth IRA contributions? The answer is… it depends on a lot of factors.

Do you have questions about retirement planning? Speak with a financial advisor today.

Age and Taxes Are the Most Important Factors

“The Roth IRA is the closest thing to a free lunch from Congress — the gift that actually keeps giving over the long term.  But that’s why the earlier one takes advantage of it, the better,” said Vijay Marolia, a managing partner at Regal Point Capital.

Alongside tax rates, age is a critical issue when considering whether to switch to a post-tax account. The younger you are, the longer this account will grow, and that can be even more impactful given you pay taxes on the contributions and not returns.

Here, in your 50’s, you’re on the bubble. You’re not in the near-unambiguous range of, say, a 25-year-old investor, but you still have some saving years left. The difference will come down to growth and taxes.

“Given your combined $1 million in 401(k) accounts, incorporating Roth IRAs into your retirement strategy is wise. Planning for retirement and making smart investment choices are vital steps for securing long-term financial stability.” said Dutch Mendenhall, CEO of RAD Diversified.

But Mendenhall also warns that it’s important to understand the rules around your various retirement options. Specifically, if you switch from traditional 401(k) contributions to a Roth 401(k) or Roth IRA, your taxes will increase. This is because you’ll lose the tax deduction for your original portfolio contributions, meaning you pay taxes on any money that goes into the Roth accounts. Now, this effect could be modest depending on the rest of your tax situation, but it should be accounted for.

Pay Attention to Contribution and Income Limits

Unless you make only modest contributions to your 401(k), which could be unlikely given a $1 million account balance, you may not be able to shift entirely to a Roth IRA. The annual contribution cap for these accounts is only a percentage of that of a 401(k). Here’s a breakdown for 2024:

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Additionally, the IRS sets income limits on who can participate in a Roth IRA. In 2024, a married couple can only fully contribute to a Roth IRA if they make less than $230,000 per year, and cannot contribute at all if the make more than $240,000.

Consider speaking with a financial advisor to build a plan for your retirement income.

Is This a Good Idea for Your Retirement Plan?

“[T]he main difference between the Roth and traditional retirement plans is based on the timing and payment of income taxes. The variable that matters most when planning for the future is your estimate of your future income, or at least a ballpark estimate,” said Marolia.

Once you have that, you need to estimate your future tax rates. The lower your tax rates in retirement, the less value you will get from a Roth IRA because you will save less on taxes now. Instead, as Marolia says, “[T]he Roth option is ideal for people that feel that tax rates will be higher in the future and for those that believe their income will continue to rise in the future.”

Essentially, with a Roth IRA you trade taxes today for no taxes tomorrow. That means that the more time you will spend in retirement and the higher your tax bracket, the more value you’ll get out of this account. On the other hand, the later you plan on retiring and the lower your taxes in retirement compared with your taxes now, the less value you will get compared with the tax-deferred nature of a traditional 401(k) or IRA.

Retirement Planning Tips

• A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• If you have significant savings, it may mean you also have significant income. In that case, the IRS might not allow you to make Roth contributions at all. Instead, you may want to consider a Roth IRA conversion.

• Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.

• Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.

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The post My Husband and I Are in Our 50s, Have $1 Million in Our 401(k)s and Want to Retire at 65. Should We Switch to Roth Contributions? appeared first on SmartReads by SmartAsset.