How a 401(k), Roth combo can help younger savers

This article will ...  Outline the tax benefits of saving simultaneously in a 401(k) and a Roth IRA.  Tell you how your tax liability may climb in retirement if you only save in tax-deferred accounts.  Explain how cash value life insurance could potentially help fund your retirement if do not qualify for a Roth IRA.

Millennials, Gen Z, and those with modest incomes listen up: You may be able to give your retirement savings a boost by contributing less to your 401(k). Huh?

Financial professionals say those who qualify for a Roth IRA are sometimes better served by contributing just enough to their 401(k) to secure any employer match that may be available, so as not to leave free money on the table, and then diverting any additional retirement savings to fully fund a Roth. There are caveats, but that’s the basic idea.

“For young people, in particular, it is huge to fund a Roth IRA to the max, but only after they get their employer match,” said Nancy Coutu, co-founder of Money Managers Financial Group in Chicago, Illinois, in an interview.

It’s all about taxes, she indicated.

Retirement funds and taxes

A traditional 401(k) is funded with pre-tax dollars, which lowers your taxable income in the year you contribute, and the money in your account can grow tax-deferred until retirement, when withdrawals are taxed as ordinary income.

The reverse is true for Roth IRAs, which are funded with after-tax dollars, so there is no immediate deduction for your contribution, but you pay no taxes on earnings as part of qualifying distributions when you withdraw. (Learn more: 8 FAQs on traditional vs. Roth IRAs)

The thought is that, over the long haul, any tax-free growth on Roth IRA (after tax) contributions might have the potential to outperform tax-deferred growth on pre-tax 401K contributions. Couto indicates this might be the case, especially for millennials who have decades of earnings potential ahead. Because their income will likely rise throughout their career, their tax bill today is also likely to be lower than it will be in retirement.

But that is not the only tax benefit to a Roth IRA.

Retirees do not need to distribute (withdraw) money from their Roth IRA account during their lifetime, which allows those funds to retain their tax-free status throughout retirement, a major perk. And, if they never need the money in their account, it can be passed along to their spouse or heirs when they die. ¹ Take note that the ability for certain non-spouse beneficiaries who inherit an IRA can stretch their required minimum withdrawals out over their own life expectancies, and thus permit those dollars to generate tax-free earnings longer, no longer exists under recent legislation (with some exceptions). But a handful of strategies still exist that may help your heirs maximize the financial legacy you leave behind. ² (Learn more: Stretch IRA? Four possible alternatives).

By contrast, the IRS requires individuals to begin taking minimum distributions from qualified retirement plans, like a 401(k), in the year in which they turn 73, and are no longer working, whether or not they need the money. (The government figures it has waited long enough to collect on all those unpaid taxes). There used to be a hefty 50 percent penalty for failure to take required minimum distributions (RMDs), but SECURE 2.0 reduced the penalty to 25 percent of the amount not withdrawn, with the possibility of reducing it to 10 percent if the mistake is corrected in a timely manner. (Related: Retirement rule changes coming in 2023).

“Uncle Sam is very patient; he gives you a little deduction today in exchange for thousands of dollars in taxes down the road,” said Coutu.

Not only do distributions from 401(k)s produce a hefty tax bill, but they get counted as provisional income in determining the portion of your Social Security check that will be subject to taxation. Distributions from a Roth, which remember are not even mandatory, are not considered provisional income in Social Security calculations. (Related: Things to know about Social Security)

“If you accumulate a lot of money in qualified plans, even if you are in the 15 percent tax bracket when you retire, your distributions may cause higher taxes,” said Greg Hammer in an interview, chief executive officer of Hammer Financial Group in Schererville, Indiana.

For a growing number of retirees, said Hammer, RMDs can elevate their tax burden beyond what they may have paid during their working years. Depending on their account balance, an RMD may push a retiree into a higher tax bracket.

“One big misconception out there is that people think they’ll pay less taxes in retirement, but the only way to pay less tax is if you have less income,” he pointed out.

Hammer said Roth IRAs are also potentially better for surviving spouses. “When people retire, they often base their entire financial plan on a double income tax bracket, but after the first spouse dies, the person now in the single tax bracket hits the 10 percent, 12 percent and 22 percent brackets sooner,” he said. “Roth IRAs not being taxed can prove to be more beneficial because even though you may be in a lower tax bracket when you retire, that may not be the case for the surviving spouse.”

Roths are more flexible

Yet another benefit of a Roth IRA over a traditional 401(k), not related to taxes, is their flexibility.

“Once money goes into your 401(k) forget it; it’s buried until you are 59-1/2 unless you want to pay penalties and taxes,” said Coutu, noting a few exceptions exist. “If you put your money into a Roth instead, you can get your principal out any time you want tax-free.”

Note: The earnings from your Roth IRA cannot typically be withdrawn before age 59-1/2  without paying ordinary income taxes and a 10 percent early withdrawal penalty, but the IRS makes several important exceptions to that penalty — including for the purchase of a first-time home or college expenses for the account holder and his or her spouse, children, grandchildren or great-grandchildren.⁴

Contribution Limits

There are limits, however, to how much you may contribute to a Roth IRA each year, and it is far lower than the limit for 401(k)s.

The total amount you can contribute to a Roth is $6,500 in 2023 and $7,000 in 2024, unless you are age 50 or older, in which case you can contribute an additional $1,000.

By comparison, employees may contribute up to $22,500 to their 401(k) in 2023 and $23,000 in 2024, plus an additional $7,500 for those 50 and older.

If, after contributing enough to your 401(k) to get the employer match and fully funding your Roth IRA, you still have retirement savings left to invest, Coutu suggests circling back to your 401(k) and maxing it out. Some employers now offer a hybrid Roth 401(k) , which also allows you to contribute up to $22,500 in 2023 ($23,000 in 2024) in after-tax contributions. Eligible employees who are age 50 or older may be able to save an additional $7,500.⁶ Roth 401(K)s are funded with after tax dollars and qualified distributions become tax free during retirement, like a Roth IRA. But because they are offered as an employer benefit they are subject to the same contribution limits and RMD requirements as a 401(k).

Retirees can potentially roll their Roth 401(K) over to a Roth IRA to avoid taking RMDs, but would have to complete the rollover before they turn 73 to avoid an RMD.

A financial professional can offer valuable guidance on how best to maximize your retirement savings.

What if I don’t qualify?

The 401(k)/Roth IRA savings strategy, however, has one big flaw: not everyone qualifies for a Roth IRA.

Indeed, you can only contribute if your income falls below a certain threshold : Married couples who file jointly with modified adjusted gross income (MAGI) of less than $218,000 for tax year 2023 ($230,000 for 2024) can contribute up to the annual limit to a Roth IRA. They can contribute a reduced amount until their MAGI reaches $228,000 in 2023 or $240,000 in 2024, at which point they are no longer eligible for a Roth IRA, according to the Internal Revenue Service.

Single filers with MAGI of less than $138,000 in tax year 2023 ($146,000 in 2024) can contribute the full amount to a Roth IRA; they can make a reduced contribution until their 2023 MAGI income reaches $153,000 ($160,999 in 2024) and nothing at all when their MAGI exceeds that amount.

“If you are young and successful, you can’t contribute to a Roth forever so take advantage of it while you can,” said Coutu.

Those who do not qualify for a Roth IRA can look at another option to supplement retirement income down the road, namely a dividend-paying, cash value, whole life insurance plan, said Daniel Blake in an interview, president and chief executive officer of Southtowns Financial Group in Orchard Park, New York. (Calculator: How much life insurance do I need?)

Whole life insurance first and foremost offers a death benefit. All internal growth is fully tax-deferred and the death benefit is generally tax free. Dividends, while not guaranteed, can offer additional value in policies that qualify for them. (Related: Whole life insurance: Criticisms and rebuttals)

“You can take cash dividends, if any, up to your (cost) basis and borrow after your basis is met,” said Blake, noting cost basis generally refers to the amount of premiums you have paid into the policy less any dividends or withdrawals you may have taken. “Withdrawals are tax-free and do not have to be paid back during your lifetime as long as your policy doesn’t lapse.” (Related: Mind your policy premiums before you get into MEC territory)

While life insurance offers some important living benefits, they are not intended to replace retirement savings, but rather the cash value could be accessed for supplemental retirement income. . It is also important to note that borrowing from your life insurance policy decreases the available death benefit and cash value, and could cause the policy to lapse, which would result in a tax bill. (Related: How life insurance can help supplement retirement income)

Those saving for retirement should carefully consider their needs and consult their financial professional for guidance.

Roth IRA contribution discipline

One final note: The 401(k)/Roth IRA savings strategy is predicated on discipline. Automated payroll deposits to your 401(k) make saving a cinch, whereas writing checks to fund your Roth IRA requires a more proactive investor.

If you don’t trust yourself to make it happen, then stick with a strategy of maxing out your 401(k) — which still offers excellent tax-deferral benefits.

Those who have the resolve, however, may thank themselves later for biting the tax bullet today.

“If you are talking to younger investors, the likelihood of them accumulating enough in their traditional IRAs and 401(k)s to produce a significant tax burden is much greater,” said Hammer. “If you divert to a Roth now, along with matching 401(k) dollars, you’re just going to have that much more flexibility down the road.”

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This article was originally published in November 2016. It has been updated.

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