The Roth Difference

As many of you navigate the world of retirement savings, you may have heard of various types of Roth(s). These include the Roth 401(k), the Roth IRA, and Backdoor Roth Conversions. Each of these options has its own unique set of benefits and considerations. In this blog, we take a closer look at each of these Roth(s) to help you determine which may be the best fit for you and your retirement goals.

What is the difference between a Traditional 401(k) and a Roth 401(k)? 

The main difference between a Traditional 401(k) and a Roth 401(k) plan is the timing of when taxes are paid. In a Traditional 401(k) plan, contributions are made with pre-tax dollars, which means you can deduct the contributions from your taxable income in the year you make them. The funds grow tax-deferred, meaning you are not taxed on the funds until you withdraw the funds in retirement. When you withdraw the money, it is considered taxable income.

In contrast, the Roth 401(k) plan allows you to contribute funds with after-tax dollars, which means the contributions are not tax-deductible in the year you make them. However, the funds grow tax-free, meaning you are not taxed on the gains when you withdraw the funds in retirement. Since you pay taxes upfront, withdrawals from the Roth 401(k) plan are tax-free.

Overall, the difference between the two plans is the timing of the tax benefits. In a Traditional 401(k) plan, you get the benefit of reducing your taxable income in the current year, but you pay taxes upon withdrawal. In a Roth 401(k), you don’t get the benefit of reducing your taxable income now, but you don’t have to pay taxes upon withdrawal. It’s essential to consider your current and expected tax brackets in retirement when deciding which plan is best for you. Here’s a fun fact: your tax bracket may actually go down during retirement. But what’s even more exciting is what you can do with those tax savings. Have you ever wondered what to do with your retirement savings? If you play around with a Bankrate Calculator, you can discover the power of both the traditional 401(k)s versus Roth 401(k)s. It’s a decision that can significantly impact your financial future. While some opt for a traditional 401(k), others opt for the Roth 401(k). And then there’s the option to split your contributions between the two. Decisions, decisions. It’s about finding the best fit for you and your retirement goals.

What is a Roth IRA and how is it used?

Let’s look at another retirement savings strategy, the Roth IRA. A Roth Individual Retirement Account (Roth IRA), is a retirement savings account that permits after-tax contributions. Unlike a Traditional IRA that requires mandatory withdrawals at a certain age, with a Roth IRA, you can leave your funds in the account as long as you live, making it a tax-efficient way to save for retirement. Once in the retirement account, the funds grow tax-free, and qualified withdrawals are not taxed. This includes contributions and investment earnings, making it an appealing investment tool for those who expect to be in a higher tax bracket in retirement. Contributions to a Roth IRA are limited based on income and change annually, so it’s essential to check current limits. Roth IRA contributions are made directly from your bank account. A custodian can manage your account to invest the funds in various investment options, including ETFs, mutual funds, and individual stocks but this is not required for Roth IRA participation. A Roth IRA can be a valuable way to diversify retirement savings with tax benefits but it’s important to understand income thresholds to determine if this is a good option for you. If your modified adjusted gross income is over $153K for single filers and $228K for couples in 2023, you cannot contribute to a Roth IRA.

You may often hear that a Roth IRA makes more sense for younger investors because they are in a lower tax bracket. It also works if you were in a year where you were making less for one reason or another. For example, if you went back to school or switched jobs and took some time off, it would be something to consider.

What’s the deal with Backdoor Roth Conversions?

Before answering that question, we need to know if you currently have an IRA with funds in it. A Backdoor Roth Conversion is a way for individuals to convert their traditional IRA balances into a Roth IRA, regardless of their income level. IRA conversions can be very complex and if not handled properly, can leave you with a surprisingly hefty tax bill, especially if done multiple years in a row. However, it’s a way for high-income earners to bypass the income limits that prevent them from directly contributing to a Roth IRA. The process involves making a nondeductible contribution to a Traditional IRA, which is allowed regardless of income level. Next, the funds are moved from the Traditional IRA to a Roth IRA in a process called a conversion. This conversion may trigger a tax liability, so it’s important to consult a tax advisor before pursuing this strategy. Backdoor Roth conversions can be an attractive option for individuals who anticipate being in a higher tax bracket in retirement or want to increase the tax diversification of their retirement savings. Understanding all the tax implications and contribution limits associated with Backdoor Roth conversions is essential before initiating one.. There are also very specific ways that this transfer must be reported on your tax returns, so if you are working with an accountant, inform them of your Roth conversion.

If you are interested in exploring these or other retirement strategies, let us know, and we’d be happy to discuss these options further.