Ed Slott, a renowned IRA and tax expert, recently shared some contrarian year-end tax planning advice in ThinkAdvisor. Instead of focusing on what clients should do, he highlighted what they shouldn't do, especially when it comes to 401(k)s and Roth 401(k)s. His main message? Prioritize long-term tax planning by favoring Roth accounts over traditional tax-deferred savings.
This advice might seem counterintuitive, especially with the allure of a tax deduction from traditional 401(k) contributions. But let's dive deeper into why Slott advocates for the Roth and explore the potential long-term benefits.
The Case for Roth
Slott argues that continuously contributing to traditional 401(k)s is like "pouring gasoline on the fire" of future tax liabilities. Why? Because while you get a tax break now, you'll pay taxes on those funds (and their growth!) in retirement.
Here's a breakdown of the key differences between a traditional 401(k) and a Roth 401(k):
| Feature | Traditional 401(k) | Roth 401(k) |
|---|---|---|
| Contributions | Pre-tax | After-tax |
| Tax Deduction | Yes | No |
| Growth | Tax-deferred | Tax-free |
| Withdrawals in Retirement | Taxed as ordinary income | Tax-free |
Let's illustrate with an example:
Assume you invest $100,000 in both a traditional 401(k) and a Roth 401(k) and achieve an average annual return of 7% over 30 years.
- Traditional 401(k): Your investment grows to approximately $761,000. However, you'll pay taxes on withdrawals in retirement. Assuming you're in the 22% tax bracket, your tax liability could be around $167,420, leaving you with $593,580.
- Roth 401(k): Your investment also grows to $761,000. But since you already paid taxes upfront, your withdrawals are tax-free, giving you the full $761,000.
1
Visualizing the Difference
Factors Favoring the Roth:
- Future tax rates: If you anticipate being in a higher tax bracket in retirement, the Roth 401(k) becomes even more attractive.
- Required Minimum Distributions (RMDs): Roth 401(k)s are no longer subject to RMDs, offering greater flexibility in retirement.
2 - Long-term growth: The longer your money grows tax-free, the greater the potential advantage of a Roth 401(k).
Slott's Other Year-End "Don'ts"
Besides advocating for Roth contributions, Slott advises against:
- Delaying Roth conversions: Take advantage of current low tax rates to convert traditional IRA funds to Roth IRAs.
- Waiting to withdraw from inherited IRAs: Beneficiaries subject to the 10-year rule should strategically withdraw funds throughout the 10-year period to minimize their tax burden.
The Bottom Line
While the traditional 401(k) offers an immediate tax deduction, the Roth 401(k) can provide significant long-term tax advantages.
Link to original article: https://www.thinkadvisor.com/2024/12/04/ed-slott-big-moves-clients-should-not-make-before-year-end-/
References:
- Slott, E. (2024, December 4). Ed Slott: Big moves clients should not make before year-end. ThinkAdvisor.
https://www.thinkadvisor.com/2024/12/04/ed-slott-big-moves-clients-should-not-make-before-year-end-/ The Secure Act of 2019 and the 10-Year Rule for IRA Beneficiaries. IRS.
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions#secure https://www.investopedia.com/roth-ira-conversion-rules-4770992