Why Tax Brackets Matter for 401(k)s and IRAs
Your income determines your tax bracket, and as it increases, only the portions that exceed each bracket threshold are taxed at the higher rates.
How Different Retirement Accounts Are Taxed
Traditional 401(k) and Traditional IRA
- Contributions: Made with pre-tax dollars, reducing your taxable income in the year you contribute.
- Taxes on withdrawals: When you take money out in retirement, withdrawals are taxed as ordinary income.
- Income restrictions: There are no limits on contributing, but whether your contributions are tax-deductible can depend on your income and whether you or your spouse are covered by a workplace retirement plan.
Roth 401(k) and Roth IRA
- Contributions: Made with after-tax dollars, meaning you don’t get an immediate tax deduction.
- Taxes on withdrawals: Qualified withdrawals in retirement are tax-free if you meet certain conditions (generally age 59½ and account held for at least 5 years).
- Income restrictions: Roth IRAs have income limits that can reduce or prevent eligibility to contribute directly. Roth 401(k)s typically do not have income limits.
Choosing Between Traditional and Roth Accounts
Your current and expected future tax brackets can help guide your decision:
- Traditional accounts may be better if you expect your income and therefore your tax rate to be higher today than in retirement. You get a tax break now, potentially saving more on taxes when your marginal rate is higher.
- Roth accounts may be more advantageous if you expect your tax rate to be higher in retirement. Paying taxes now at a lower rate allows your contributions and earnings to grow tax-free, giving you more flexibility later.
Planning Your Contributions
Knowing your likely tax bracket can guide how much you may want to contribute to each account type. For example, imagine you’re 40, maxing out your 401(k), and also contributing to a Roth IRA. By estimating your bracket, you could split contributions strategically:
- Max out your Traditional 401(k) to reduce taxable income now.
- Contribute to a Roth IRA if you anticipate higher taxes in retirement.
This way, you’re creating a flexible retirement plan. Down the road, you can choose withdrawals that minimize taxes depending on the situation.
