401k? A Roth? Which is Right for Me?

If you’re like most retirement savers, you regularly hear a lot of industry acronyms and jargon thrown around by the media, by friends and family, by your employer, and perhaps your financial professional too. Things like the 401k, the 403b, the IRA, the SEP-IRA, the Roth IRA, the Roth 401k . . . I know it’s a lot.  And these are just a few of the many savings options that most Americans have to choose from when saving for retirement. Now folks, I’m all for having options. After all, there is not one retirement savings plan that is best for everyone, and many people will likely benefit from using a variety of them to save most efficiently. 

So just how do you decide which ones make sense for you? Well, as with most things, the answer is “it depends.” Take a conversation I had recently with Janice and Mike, a nice couple from Plymouth.  They are both in their mid-50’s, hard working folks around my age, mid-50’s or so. They both have amassed almost $2.5 million between their respective 401k plans. They had read a column of mine on Roth conversions and were wondering if this was a good time to adjust their strategy to convert some of their 401k funds into a Roth IRA to help reduce their tax burden in retirement.

As a refresher, a 401k plan is a tax-advantaged retirement plan that is set up and managed by your employer. Basically, you put money into the 401(k) where it can be invested and grow tax deferred over time. In most cases, you choose how much money you want to contribute to your 401(k) based on a percentage of your income. The tax deferral feature means that any funds you contribute to it while you are working is deducted from your current income, reducing your tax bill. Of course, those “Washington Wizards” don’t give anything for free, so as a trade-off, you will pay income taxes on these funds when you start withdrawing them in retirement.

Now, decades ago, traditional retirement planning meant socking away as much as you could into your employer 401k. (If you work for a school district, your plan is similar but is referred to as a 403b, which reflects the IRS code that permits it). The thinking back then was that workers will reduce their lifestyle in retirement – thus decreasing their income needs and placing them into a lower tax bracket. It meant more money in your pocket while you’re working, with the tax burden being delayed until your income needs decreased in retirement. But unfortunately, life hasn’t played out this way for many.

A couple of things have made this thinking obsolete. For beginners, retirees today are not content to downgrade their lifestyle once they retire. As life expectancies continue to increase, many folks are looking to retirement as the next phase of their lives. They are healthier and wealthier than past generations and want to be active. That takes money, naturally.

Then consider the tax climate we are facing. Tax rates today are at record lows when you consider historical rates. In fact, between 1954 and 1963, top earning Americans saw their income taxed at an astounding 91%! With the Tax Cuts & Jobs Act (TCJA) expiring at the end of 2025, tax rates are slated to increase for all income levels. Add to this a government deficit of over $34 trillion and financial struggles with the Social Security and Medicare Trust funds, the potential for higher taxes in the future is quite likely. 

With Janice and Mike’s situation, they deferred taxes on their 401k contributions for years at tax rates that are likely lower than those which will be in effect during their retirement. This means that every withdrawal they make from those accounts in retirement will be reduced and their spendable income less – perhaps significantly less. 

Hmmm . . . But they have options.

A chance to head off that “tax uncertainty” now by using the Roth conversion strategy. This concept involves converting a portion of their 401k money into a Roth IRA, which is an individual retirement account they own outside of their employer 401k plan. In this case, for example, they could withdraw funds from the 401k, pay the income taxes due at today’s tax rates, and then place the funds into a Roth IRA. Because the Roth is funded with after-tax dollars, it can grow tax free and any qualified withdrawals from it are tax free – forever! Since they paid the income taxes due at the time of the conversion, they don’t owe taxes on the principal or any future growth, assuming they wait until they are age 59-1/2 and the account is at least 5 years old. As an added bonus, these funds are also not subject to the Required Minimum Distributions at age 73 that other qualified retirement funds are. These tax-free withdrawals will not be counted as income in retirement, which can increase their eligibility for things like tax-free Social Security benefits.

Of course, this strategy won’t be right for everyone. For example, you need to ensure you have the funds available to pay the taxes due on the converted funds now so that you don’t have to tap into your retirement savings for this. The converted funds will be treated as income in the year they are transferred which could bump you up into a higher tax bracket for that year. A lot of factors and assumptions (like future tax rates) go into these calculations, so you need to run the numbers and figure out which path will save you the most in taxes over your lifetime. 

So what approach makes sense for you? Moving all or a portion of your contributions to a Roth 401(k) gives you greater tax diversity but ultimately you should run the numbers and weigh your options. Armed with this information you’ll be in a better position to decide how to create a more tax-efficient and successful retirement.

So as always - be vigilant and stay alert, because you deserve more!

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield, MA. 

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