I’m 38, finally debt-free, and making over $300k – should I start contributing to a Roth 401(k)?

Meet Sarah, a 38-year-old lawyer who has finally paid off her student loans after years of hard work. Now that she’s debt-free and earning over $300,000 a year, she and her spouse are enjoying a new level of financial freedom. Until now, Sarah has been contributing to her pre-tax 401(k), but her company offers a Roth 401(k) option, and she’s wondering whether it’s time to start taking advantage of it.

Sarah is in a great position to start thinking strategically about her retirement, and understanding the pros and cons of a Roth 401(k) is key to making an informed decision.

1. How a Roth 401(k) Works

A Roth 401(k) is similar to a traditional 401(k) in that it allows you to contribute money toward your retirement, but the key difference lies in how the contributions are taxed. In a traditional 401(k), contributions are made pre-tax, reducing your taxable income today, and taxes are paid when you withdraw the money in retirement. With a Roth 401(k), contributions are made after taxes, meaning you pay taxes on the money now, but your withdrawals in retirement—including any investment gains—are tax-free.

Sarah’s high income puts her in a position where she’ll need to weigh whether the upfront tax savings of a traditional 401(k) outweigh the benefits of tax-free withdrawals later in life.

2. The Pros of Contributing to a Roth 401(k)

Here are some key reasons why Sarah might want to start contributing to a Roth 401(k):

• Tax-Free Withdrawals in Retirement: One of the biggest benefits of a Roth 401(k) is that all withdrawals in retirement are tax-free, as long as Sarah is over 59½ and has held the account for at least five years. This could be incredibly valuable if Sarah expects to be in a higher tax bracket in retirement or if tax rates increase in the future. By paying taxes now at her current rate, Sarah could avoid paying taxes later when her account has grown significantly.
• Tax Diversification: By contributing to both a traditional and Roth 401(k), Sarah can diversify her tax exposure. Having tax-deferred accounts (like a traditional 401(k)) and tax-free accounts (like a Roth 401(k)) gives Sarah flexibility when deciding which accounts to draw from in retirement. This could help her manage her tax liability more effectively in the future, allowing her to pull from whichever account provides the most tax-efficient strategy at the time.
• No Required Minimum Distributions (RMDs) on Roth IRAs: While this benefit applies to Roth IRAs, not 401(k)s, it’s worth noting that Sarah could potentially roll over her Roth 401(k) into a Roth IRA upon retirement. Roth IRAs do not have required minimum distributions (RMDs), meaning Sarah could allow her money to grow tax-free for as long as she wants without being forced to take withdrawals at age 73, unlike a traditional 401(k).

3. The Cons of Contributing to a Roth 401(k)

However, there are some drawbacks to a Roth 401(k) that Sarah should consider:

• No Immediate Tax Break: Since Roth 401(k) contributions are made with after-tax dollars, Sarah won’t get the immediate tax reduction she enjoys with her traditional 401(k). For someone in a high-income bracket like Sarah, this could be a significant disadvantage, as she’s in a 35% or higher tax bracket. Contributing to the traditional 401(k) helps reduce her taxable income today, which could save her thousands of dollars in taxes each year.
• Uncertain Future Tax Rates: While the appeal of tax-free withdrawals in retirement is strong, it’s important to remember that tax rates in the future are unpredictable. If Sarah ends up in a lower tax bracket in retirement than she is now, she may regret paying higher taxes on her Roth 401(k) contributions today. The tax-free benefit is only valuable if her future tax rate is equal to or higher than her current rate.

4. Blending Both: The Best of Both Worlds

This is not financial advice – just my opinion, but one solution for Sarah might be to split her contributions between her traditional and Roth 401(k) accounts. This strategy could allow her to enjoy both the current tax deduction from her traditional 401(k) and the tax-free withdrawals in retirement from her Roth 401(k).

For example, she could contribute 50% to her traditional 401(k) and 50% to the Roth 401(k). This way, she reduces her taxable income today while also building a tax-free source of income for the future. The key here is tax diversification—Sarah wouldn’t be putting all her eggs in one basket and would have more options when it comes time to withdraw in retirement.

Looking Ahead

Sarah is in a strong financial position now that her student loans are behind her, but deciding between a traditional and Roth 401(k) is a critical step in planning for her future. While contributing to a Roth 401(k) would mean paying taxes now, it could provide substantial tax benefits in retirement, especially if tax rates increase or she expects to be in a higher tax bracket later in life.

Ultimately, Sarah might consider blending her contributions between both traditional and Roth 401(k)s to take advantage of both strategies. By diversifying her tax exposure, she can protect herself against future tax rate changes and give herself more options when it comes time to withdraw.

As Sarah plans for the long-term, she may also want to consult a financial planner who can help her weigh the benefits of each account type and create a retirement strategy that best aligns with her goals, income level, and potential tax liabilities. With thoughtful planning now, Sarah can build a retirement portfolio that balances growth with tax efficiency, ensuring she maximizes her wealth for the future.

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