Maximizing Estate Planning Goals with Roth 401(k) Contributions

When deciding how to contribute to your 401(k) plan, you may choose between pre-tax (traditional) contributions and after-tax (Roth) contributions. The best choice depends on your current and future tax situation, as well as your estate planning objectives.

Traditional vs. Roth 401(k)s

The primary distinction between a traditional and Roth 401(k) mirrors the difference between traditional and Roth IRAs: how they’re taxed. Traditional 401(k) contributions are made with pre-tax dollars, offering an immediate tax deduction, but both contributions and earnings are taxed upon withdrawal. Roth 401(k) contributions, on the other hand, are made with after-tax dollars, meaning withdrawals of both contributions and earnings are tax-free, provided the account meets certain conditions. Unlike Roth IRAs, Roth 401(k) plans have no income limits, making them accessible to all income levels.

In 2024, the salary deferral limits for both types of 401(k) plans are $23,000, with an additional $7,500 catch-up contribution for those aged 50 or older. The combined contribution limits (including employer contributions) are $69,000 or $76,500, depending on your situation.

Distribution rules are similar for both traditional and Roth 401(k) plans, with penalty-free withdrawals available at age 59½, or earlier in the case of disability or death. However, a Roth 401(k) must be open for at least five years before withdrawals become tax-free. A key difference is that traditional 401(k)s are subject to required minimum distributions (RMDs) starting at age 73 (or 75, for those reaching this age after 2032). Roth 401(k)s, however, will no longer be subject to RMDs starting in 2024.

From a tax perspective, the decision between a Roth and a traditional 401(k) hinges on your expectations for your future tax bracket. If you anticipate being in a lower tax bracket in retirement, the upfront tax benefit of a traditional 401(k) may be more advantageous. Conversely, if you expect to be in a higher tax bracket during retirement, or believe taxes will increase, a Roth 401(k) may be the better option.

Estate Planning Considerations

In addition to tax considerations during your lifetime, it’s important to factor in estate planning implications. The elimination of RMDs for Roth 401(k)s makes them a valuable tool for estate planning. If you don’t need the funds for living expenses, you can leave them in the account to grow tax-free, potentially for the rest of your life. Additionally, your heirs can withdraw these funds tax-free if the account has been open for at least five years.

Traditional 401(k)s, on the other hand, require you to start drawing down the account due to RMD rules, potentially reducing the amount available for your heirs. Moreover, any withdrawals made by your heirs from a traditional 401(k) will be subject to income tax.

If you need guidance on determining which 401(k) option aligns best with your financial and estate planning goals, please reach out for assistance.