401(k) contribution types: What to consider
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For a large number of workers, the primary vehicle for retirement savings comes through their 401(k). Half the battle is simply making contributions to these accounts and if you are doing that, good for you. However, many Americans don’t give much consideration to the typeof contribution that they are making. Making an informed decision on whether to make traditional, Roth, or even after-tax contributions can have a big impact on what your retirement will look like.
Traditional Contributions
Unless you indicate otherwise, any contributions made to your 401(k) are going to fall into this category. The benefit of traditional contributions is that you receive an above-the-line deduction for the cumulative amount contributed each year, meaning that the amount contributed is deducted from your income before calculating your adjusted gross income (AGI). The trade off is that when you withdraw from the traditional portion of your 401(k), any amounts withdrawn are included in your ordinary income and are taxable.
Above-the-line deductions are impactful not only because they ultimately reduce the amount of tax owed, but also because the qualification for certain tax breaks and credits is based on AGI which is calculated after accounting for above-the-line deductions. Given that many high earners can be phased out from these benefits, it is important to leverage any opportunity available to them to reduce their AGI.
Roth Contributions
While traditional contributions provide you with a tax benefit in the near term in exchange for tax owed in the future, Roth contributions work in the reverse order. Any amount contributed to the Roth portion of your 401(k) will still be included in your earned income for the year. However, at retirement, you now have a bucket from which to draw on without incurring taxes.
Keep in mind that not only are the contributions withdrawn tax free, but any earnings associated with them will also receive that tax-free treatment, so long as the account has been open for at least 5 years and you have reached age 59.5. Traditional contributions do provide a benefit now, but it is important to understand your time horizon for retirement and the possible growth that your contributions could experience. Keep in mind that any amount withdrawn from the traditional bucket, whether it be contributions or growth, will have a direct impact on your taxable income in the year withdrawn. And given how long most peoples’ time horizon is, that growth can be astronomical.
Another key consideration for high earners is that they are likely phased out from making direct Roth IRA contributions. Additionally, if they also have a balance in a pre-tax IRA (traditional, SEP, SIMPLE), they are now ineligible to make backdoor Roth IRA contributions without incurring additional taxes associated with the pro-rata rule. Given this inability to build a tax-free bucket, the 401(k) often becomes their only option for doing so. Thus, it is imperative to review your priorities: do I want to maximize my possible deductions and credits now, or do I want to have multiple tax buckets to pull from in retirement? There is no objective, correct answer. This is why it is so crucial to be informed when making your decision.
After-Tax Contributions
The last option is one that is either overlooked or people simply are not aware of. Employees under age 50 are limited to $23,000 in cumulative contributions between Roth and traditional deferrals in 2024. Employees aged 50 and older are granted an additional $7,500. However, the maximum amount that may be contributed, from all sources, in 2024 is actually $69,000 ($76,500 for those 50 and older).
Say a 35-year-old contributes the maximum of $23,000 in 2024 and their employer contributes $10,000. There is still $36,000 that can be contributed. How can they take advantage of that gap? They can make after-tax contributions up to the $69,000 limit, so long as their plan allows for it.
This strategy is very similar to making Roth contributions in that the amount contributed is still included in the participant’s earned income for the year. The caveat is that any growth associated with these contributions will be taxed when withdrawn. A popular strategy for people who make after-tax contributions is to immediately roll these contributions from their 401(k) into their Roth IRA, thus avoiding taxes on the growth. This strategy is commonly referred to as a Mega Backdoor Roth contribution.
Summary
In conclusion, there are various contribution types and strategies that can be deployed when utilizing your 401(k) to plan for retirement. While it can feel intimidating, understanding the pros and cons of each option can empower you to make informed decisions about what retirement could look like for you.
Nick Rosebraugh, CFP, is a Financial Planning Coordinator at Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.BedelFinancial.com or email Nick at nrosebraugh@bedelfinancial.com.