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How Should High Net-Worth Women Use Their 401(k)?

How Should High Net-Worth Women Use Their 401(k)?

November 17, 2020
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The 401(k) allows (most) account owners to stash away nearly $20,000 per year (or more than $25,000 for those age 50 and over), without paying any federal income tax on contributions. And with the Tax Cuts and Jobs Act reducing the top marginal tax rate for just about all tax filers, this could be a good time to reduce your pre-tax income. How can high net-worth women optimize the use of a 401(k)?

Reduce Your Marginal Rate to Open Other Doors

Many high net-worth women earn too much to contribute to a post-tax Roth IRA. But because each dollar contributed to a 401(k) can reduce a taxpayer's adjusted gross income, contributing enough to reduce your top marginal rate can open up other retirement doors, whether this is a direct Roth contribution or a Roth conversion at a lower tax rate.

As an example of this latter opportunity, a single taxpayer who earns $100,000 would previously have been in the 28 percent bracket. This taxpayer is now in the 24 percent bracket, and if she contributes $19,500 to a 401(k), can reduce her taxable income to fall into the 22 percent bracket. This allows her to convert her prior-year 401(k) or IRA contributions into Roth IRA contributions while paying no more than 22 percent tax.1 Not only can qualified Roth contributions be withdrawn at any time, tax-free and without penalty, but they also aren't subject to required minimum distributions (RMDs) like other retirement plans.

For example, if you've made $50,000 worth of Roth IRA contributions over a ten-year period, you later can withdraw up to $50,000, tax-free, at any time to purchase a new car, send a child to college, pay off a mortgage, or donate to charity.

Investigate Your Roth 401(k) Options

Many 401(k)s offer a Roth option, allowing account holders to stash away up to $19,500 in post-tax retirement contributions that will never be taxed again. Although the Roth 401(k) doesn't offer the same instant tax savings as a traditional 401(k), and may not make much sense for taxpayers who expect to be in a lower tax bracket during retirement, it can provide a great deal of flexibility for those who may be contemplating early retirement or a later-in-life career change.

Roth 401(k)s are more like traditional 401(k)s (or traditional IRAs) when it comes to making withdrawals. Unlike Roth IRAs, Roth 401(k)s don't allow account holders to withdraw their contributions early, and Roth 401(k) accounts are also subject to required minimum distributions. However, Roth 401(k)s can still be a tax boon for anyone who thinks their future income (and tax rate) is likely to increase.

Evaluate Your Draw-down Order

When you're getting closer to retirement, the operative question becomes not "how much money do I need?" but "where should I get my money?" Not only do the various retirement accounts have different tax treatment, but they also have different withdrawal requirements—exhausting your tax-free options like the Roth early in retirement can mean even higher required minimum distributions from your 401(k) after age 70, significantly increasing the total tax you pay on your retirement funds.

A financial professional can create a draw-down plan that accounts for the balance, tax treatment, withdrawal restrictions, and likely future tax treatment of each retirement account to ensure you're making withdrawals in the most tax-efficient way you can. In many cases, this means front-loading one's 401(k) withdrawals to reduce future RMDs and saving tax-free money for later.

Important Disclosures:

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal advisor.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation.

1https://www.investopedia.com/taxes/how-gop-tax-bill-affects-you/

Sources


https://www.nerdwallet.com/blog/investing/roth-401k-vs-401k/


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