Roth 401k vs 401k for High Income Earners
Roth 401k vs 401k for high income earners can be a crucial decision that will either cost you a lot of money or save you a lot of money as you get older.
There are many similarities between a Roth 401k and a 401k, but there is a single difference in how they deal with taxes that will greatly influence the amount of money that you get out of it.
But, before we look at the similarities and differences between a Roth 401k and a 401k and how they influence you as a high income earner, let's first look at what they are.
What is a Roth 401k and a 401k?
What is a 401k?
A 401k is an employee-sponsored retirement account. Generally, employees can contribute a portion of their income to the account, and their employers will match that amount up to a certain point. Generally, the maximum contribution to a 401k is $20,500 for people under the age of 50 as announced by the IRS in November 2021, and $27,000 for people over the age of 50.
The key aspect of the 401k that will affect high income earners more than anyone else is when the money is taxed. In the case of the 401k, the money is contributed pre-tax. Taxes are deferred to the day that money is taken out of the account.
What is a Roth 401k?
A Roth 401k is not entirely separate from a regular 401k, but is instead a feature of it that is offered in most, but not all instances.
Because it is a feature of a 401k rather than a separate retirement account entirely, most of the aspects of a Roth 401k and a 401k are identical. This includes the maximum contributions.
However, the key difference is related to tax. Any money that is placed into the Roth 401k is contributed after taxes. Because the tax has already been paid on this money, taxes will not be paid when it is withdrawn, and any growth is also tax free, provided that the money is left in the account for a minimum of 5 years, and that the person withdrawing is at least 59 ½, which the IRS outlines here
How do Roth 401k vs 401k Taxes Affect High Income Earners?
The important thing to consider regarding taxes and tax savings between the Roth 401k and the 401k as a high income earner is what you suspect you will be earning in the future.
High Income in the Future
Many high income earners will continue to earn high incomes, placing them in the top tax brackets, in the future. The reason for this is often because of investments that are paid out such as dividends and real estate income.
In cases like this there is the risk that income taxes will change, increasing in the future and causing you to pay more tax than you would now. If this is a worry, then it might be better to pay taxes now, and contribute to the Roth 401k. Of course, there is also risk with this as there is the possibility that taxes for high income earners would decrease in the future, in which case you would make an overall loss in comparison.
It is best to consult with a financial advisor and consider the state of the country at the time of investing, as well as how far away you are from retirement. These factors will all affect the potential risk/reward.
Lower Income in the Future
Although you may still have many assets in the future, there are ways in which current high income earners can minimize their overall income in the future, dropping a few tax brackets.
Some examples of this include investing in high growth stocks with low dividend payments, transferring much of your wealth to a trust, or simply cutting back on all active income by retiring.
We have covered various types of trust, they include a generation skipping trust, spendthrift trust, trust decanting, personal property trust, and separate property trust.
In cases like this, you may be paying a lot less tax in the future than you would at the moment and it would be better to delay paying tax on the money in the retirement account. Here a 401k would be the better option.
Of course, there are still risks attached, but overall this is a safer option.
Unsure about Future Income
Many people are unsure about what they will be earning in the future. If you are young, and earning a large income, that does not mean that you can guarantee that same income indefinitely. If you are older, you might still be unsure about whether you would like to retire completely.
In cases like this, there is no need to worry about whether you are making the correct decision for yourself in terms of taxes. Instead, you can contribute to both a Roth 401k and a 401k. This would minimize the risks, but also minimize the rewards regarding tax based losses.
Roth 401k vs 401k for High Income Earners: Conclusion
Roth 401k vs 401k for high income earners is a decision that can save you a lot of money in terms of taxes. If you are a high income earner now and suspect that you will be earning a high income in the future, it is recommended to go with a Roth 401k in order to minimize the risk of taxes increasing, but you must understand that you will lose out if taxes for high income earners decrease.
Alternately, if you think you will have a much lower income in the future then it may be better to defer your taxes and pay in the lower bracket through the use of a 401k.
In this case however, you may be forced into retirement or the implementation of other ways of cutting your income, even if you change your mind, or you would be forced to pay in a higher tax bracket anyways.
There are risks to both, and due to the high tax nature of high quantities of money even a small change could cause a large profit or loss. For this reason it is recommended that you speak to a financial advisor before deciding on which to invest in, if any.
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