Recently, there has been renewed discussion about whether employee investors should make traditional pre-tax contributions into their employer-provided 401k plan or take advantage of the Roth 401k option. Over the past several years, many employers have added a Roth 401k option to their retirement plan offering, which is the basis for the increased discussion.
What is a Roth 401k?
Roth 401k accounts are retirement accounts that are provided by your employer which are funded with after-tax contributions. The participant’s contributions are subject to tax when they are made. Therefore, they can be withdrawn tax-free during retirement. The tax-free benefit includes the distribution of contributions and the subsequent investment gains.
Before digging deeper into the analysis, let’s discuss some of the key characteristics of these two options.
- The timing of taxation is the primary difference between the two options. Roth 401k contributions are made on an after-tax basis which means that you do not get a reduction in income tax in the year you make the contribution. In contrast, the traditional 401k contribution is made on a pre-tax basis which reduces your taxable income for the year of contribution.
- Roth 401k contribution limits are the same as traditional 401k funding limits ($18,000 per year, plus $6,000 catch-up if over 50 years of age). In comparison, Roth IRA contributions are limited to an annual funding amount of $5,500 per person with a $1,000 catch-up provision for those over 50. Clearly, if making a Roth contribution is your preference, participating in the Roth 401k is preferable to a Roth IRA because of the increased funding limits.
- Roth 401k funding and participation does not have the taxable income limit that a Roth IRA account has. Married taxpayers with adjusted gross Income over $184,000, ($117,000 for single taxpayers) are not allowed to make Roth IRA contributions. Thus, many people that would not be allowed to fund a Roth IRA account due to the income limitation can fund a Roth 401k account.
- Employer matching contributions are always funded into the traditional 401k irrespective of the employee’s deferral choice of participating in the Roth or traditional option. By participating in the Roth 401k option, the employee will have both after-tax and pre-tax balances in their retirement plan.
- Roth 401k accounts are subject to the required minimum distribution rules which require the participant to begin taking distributions upon reaching 70 ½ years of age. This is in contrast to a Roth IRA which has no required minimum distribution requirement.
- Roth 401k accounts can be rolled into Roth IRA accounts just like traditional 401k accounts are rolled into traditional IRA accounts. Transferring Roth 401k contributions to a Roth IRA will allow the participant to avoid having to take required minimum distributions upon reaching age 70 ½.
Why should I contribute to a Roth 401k?
If you believe your future tax rate in retirement will be higher than your current tax rate, you should use the Roth option. This would be especially important to younger participants that have a lower current income tax bracket (which means less tax benefit from traditional 401k pre-tax contributions) and many years to benefit from the tax-free compounding and growth.
Also, the Roth account can be a useful estate planning tool. If you anticipate that these retirement funds will not be needed during your retirement, the Roth planning option can maximize the money left to your children or heirs because there will be no tax consequences associated with these funds. As a reminder, income tax was paid in the year the contribution was made.
Why should I contribute to a traditional 401k?
If you are currently in a higher tax bracket and anticipate a lower taxable income in retirement, you would choose to take the benefit of making the pre-tax contributions and deferring the payment of the tax into your retirement years. This would be more applicable for the participants that are typically older, in their high-income years and don’t have the benefit of the additional years of tax-free compounding before they will need to access their retirement funds.
Is there a case for both?
Yes, there is a case for making both types of contributions. Just as many investment advisors encourage their clients to diversify the stocks and bonds in their retirement portfolio, there is also an argument for diversifying your tax exposure on your retirement accounts.
By making both contributions, you are accomplishing this diversification by having the Roth portion of your retirement portfolio not subject to any income taxation. Another benefit of Roth funding is that if it is rolled into a Roth IRA there are no required distributions. This allows you to control your taxable income during your retirement years by choosing which account, pre-tax or after-tax, you distribute funds from. Additionally, the traditional 401k part of your retirement accounts will be subject to tax as the money is distributed. The basic underlying assumption is that you will have less income and therefore lower taxation on those funds during retirement.
In summary, there is no totally correct answer on this decision because there are so many variables. When you are contributing to a traditional 401k, you are contributing on a pre-tax basis which means you get a tax break up front and have to pay taxes when you distribute the money during retirement. Conversely, if you use a Roth account, you are funding with after-tax dollars and the money you contribute plus the earnings on that money is distributed without any tax consequences.
As stated in the title above, it is all about the taxes!!! Do you prefer to pay them now or pay them later? Unfortunately, you will have to pay them.