Should I quit 401(k) for tax-free option?

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Q. I have a traditional 401(k). I want to have some tax-free retirement assets, too. What are the pros and cons of lowering my 401(k) contribution to put money into a Roth IRA?
—Trying to balance

A. First off, kudos to you for being so proactive in thinking in-depth about your retirement savings.

With a traditional 401(k), the money you contribute is pre-tax and is deductible in the tax year you make the contribution, said Michael Cocco, a certified financial planner with AXA Advisors in Nutley. That’s a major benefit of using the plan.

“The money accumulates tax-deferred, so you will not receive a 1099 for any dividends, interest, or capital gains that are generated from the account,” Cocco said. “However, once you start withdrawing from this traditional 401(k), you will pay ordinary income tax on all monies withdrawn in that tax year — both principal and earnings — at your tax rate at that time.”

The philosophy behind this savings technique is that when you are in your prime working years and earning a high degree of income, the tax deduction is meaningful to you. Then when you withdraw these funds at retirement, you could be in a lower tax bracket because you may not be working or you may be working a lot less, so you will pay taxes at a lesser percentage versus in the year in which you received the deduction, Cocco said.

Cocco said much like diversifying the investments you use to save for retirement is important, it’s also important to consider diversifying the taxable buckets in which you have money to pull from at retirement, giving yourself options.

That’s where contributing to a Roth IRA comes into play.

Roth IRA contributions are made using after-tax money, meaning that the money contributed has already been taxed, and you receive no tax deductions in the year you make the contribution, Cocco said.

“However, this money also accumulates tax-deferred and can be accessed tax-free — both the principal and the earnings — once you turn age 59 1/2 and have had the monies in the Roth IRA for at least five years,” Cocco said.

He said contributing to a Roth IRA can have benefits because it ensures that not all of your retirement assets will be taxed upon withdrawal, so you can work with your financial advisor and tax professional to craft a strategy on when to withdraw from each account —and how much — depending on your tax situation at that time.

Additionally, Cocco said, Roth IRAs give you a degree of accessibility to funds without tax or penalty — as your principal contributions are accessible to you at any age.

It is very important to note that there are income limits to be eligible to contribute to a Roth IRA.

For 2017, you can make the full $5,500 Roth IRA contribution ($6,500 if you are over age 50) if your modified Adjusted Gross Income (AGI) is $118,000 or less. You can make a partial Roth IRA contribution if your income is between $118,000 and $133,000, and you would not be able to make any Roth IRA contributions if your income is over $133,000. For those married filing jointly taxpayers, your combined income must be less than $186,000 for a full contribution, it’s phased out if income is between $186,000 and $196,000, and not allowed if your income is more than $196,000.

“If you are able to contribute to a Roth IRA and elect to do so, I would advise ensuring that you do not lower your 401(k) contributions too much that you may miss qualifying for all of the employer matching contributions you may be eligible for,” Cocco said.

He recommends you speak to your accountant or tax advisor to have them review what may be best in your personal situation, and have them work with your financial advisor to ensure that all members of your professional planning team are working together to give you the proper advice.

Email your questions to moc.p1501044146leHye1501044146noMJN1501044146@ksA1501044146.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.