I split my 401(k) contributions 50/50 between a standard and a Roth. The thought process is that it allows me to withdraw money tax-free on large expensesears in retreat athe opposite in normal years. Is this the correct thought process and a good idea?
Planning your retirement involves balancing what you want to put aside now and what you’ll pay in taxes later when you retire.
For these reasons and others, splitting your retirement savings between a traditional 401(k) and a Roth 401(k) — or IRA — is a good idea.
In a traditional 401(k) you make pre-tax contributions and pay taxes on your withdrawals. Contributions to a Roth 401(k) are already taxed, so withdrawals are tax-free as long as you’ve had the Roth account for at least five years.
While not everyone has employer-sponsored Roth offerings or even 401(k), the option of distributing your retirement savings in a similar way can be done on your own using both a traditional IRA and a Roth IRA.
“It comes down to taxes,” says Catherine Golladay, senior vice president of Schwab Retirement Plan Services in Richfield, Ohio.
The problem, especially as a young person, is that no one knows what will happen to your tax rates or your income between now and retirement, and those things can make a big difference.
Traditional vs. Roth – or both?
“Many young people, as they grow in their careers, expect to earn more and fall into a higher tax bracket,” says Golladay.
In that case, it may be beneficial to put money into a Roth when you’re younger and your tax bracket is lower.
“For younger workers, they have a longer window to grow those contributions tax-free,” says Golladay.
Related: Should I take out a loan to pay off my debts?
People in their 40s, 50s or 60s don’t have that much time to grow that money. However, if you’re thinking about a Roth and you’re more than five years away from retirement, Golladay suggests contributing a little, too.
You can withdraw 59½ from a Roth. The only caveat is that it takes five years from your first contribution to be able to withdraw your earnings tax-free.
“I’ve seen people put as little as 1% [of their retirement savings] to the Roth to start the five-year clock,” he says. The annual limit for all 401(k) contributions in 2018 is $18,500.
But if the tax burden of setting aside retirement funds as they are and going all Roth is too much right now, splitting your contributions between traditional and a Roth may be a good option.
The benefits of tax diversification
In addition to changing the tax burden as you pay into retirement funds and allowing flexibility when you’re retiring, there are other benefits to a traditional/Roth 401(k) split.
“When you have those options, more sophisticated tax strategies come into play,” says Golladay.
If you are going to retire and pass the mandatory retirement age of 70 and a half, you have some room to maneuver. Of course, you’ll need to take required minimum distributions from both account types after age 70 ½, but Roth 401(k) withdrawals will be tax-free.
Closer to retirement, you may want to roll both over to a Roth IRA to avoid required minimum distributions. You don’t have to take required minimum distributions from a Roth IRA until the owner dies. Or, you can roll a traditional 401(k) into a traditional IRA and a Roth 401(k) into a Roth IRA to maintain tax diversification.
Related: How to save for retirement without a 401(k).
“In years when an individual has high expenses, having that extra amount of money come from a tax-free source — the Roth — is a huge benefit,” says Golladay.
The other thing people see doing is using both funds to manage their marginal income tax, he says. They can take some money out of the tax-deferred fund, and they’ll take anything beyond a certain amount that’s needed to keep them from rolling over from their Roth to the next income bracket.
“With a 50/50 you’re maximizing your tax diversification strategy,” says Golladay. “Even if you don’t know what tax bracket you’ll be in after retirement, you have the best of both worlds.”
Got a money question on Money Moves? Apply here to be included in a future column.
CNNMoney (New York) Posted May 10, 2018: 1:24 pm ET