In praise of the under appreciated Roth 401(k) retirement account

This article explains the difference between traditional 401(k) plans and the Roth 401(k). For many of our clients, making contributions to the Roth portion of their 401(k) plan might be the better option that they have never even considered.

401(k) basics

A 401(k) is a workplace retirement plan.

Your employer sets up the 401(k) with a financial institution. The employer decides which investment options are available.

You, as the employee, decide how much money you set aside for retirement through the 401(k) plan. You also choose whether your savings are contributed on a pre-tax basis or on an after-tax basis. And you choose which investment funds (among the options pre-selected by your employer) into which your savings are invested.

A 401(k) plan is different than an individual retirement account (IRA). An IRA is a retirement savings plan covering just one individual, while a 401(k) plan is a group plan covering all the employees of a business. Many of the same principles about whether to fund a retirement plan using traditional or Roth contributions apply to IRAs as well as 401(k) plans.

You can contribute up to $18,500 per year to your 401(k) plan. This limit on the amount of money employees can contribute changes slightly each year. For 2017, the limit was $18,000. Employees who are at least 50 years old can set aside an extra $6,000 in their 401(k). Such “catch-up contributions,” as they are called, mean that workers age 50 or older can save up to $24,500 each year through their 401(k) plan.

Employers can make contributions to the 401(k) plan on your behalf as well. Employer contributions often are based on how much you contribute as an employee. An employer might match an employee’s contribution dollar for dollar up to 3% of salary, for example. Each employer will come up with their own method for determining how much money the employer will contribute to the retirement plan. The primary recommendation here is that employees should consider contributing at least enough savings to their 401(k) to be eligible to receive matching contributions from the employer, as this is a great way to boost how much money is saved for retirement.

Funding Your 401(k) Plan: Pre-Tax or After-Tax Contributions

When funding their 401(k) plan, employees choose whether they will contribute funds on a pre-tax basis, or on an after-tax basis, or some combination of the two. The primary differences between pre-tax (“traditional”) contributions and after-tax (“Roth”) contributions is the tax treatment at the time of the contributions and the eventual tax treatment when the funds are distributed from the plan in the future.

Pre-tax contributions to a 401(k) plan are deducted from your paycheck before federal and state income taxes are calculated. This reduces your taxable salary, resulting in a lower tax liability today. Going forward, the money that is inside the 401(k) plan grows tax-deferred, meaning any interest or dividends or capital gains are not taxed when generated. Rather, both the investment earnings and original the pre-tax contributions are taxed in the future when money is dispersed from the plan. With pre-tax contributions to a traditional 401(k) plan, you are opting to avoid taxes today and instead pay taxes later.

After-tax (Roth) contributions to a 401(k) plan are deducted from your paycheck after federal and state income taxes are deducted. Roth contributions do not reduce your salary for tax purposes. That means Roth contributions do not reduce your tax liability today. The advantage is that Roth contributions, plus any investment earnings on the Roth contributions, are not taxed in the future when the money is dispersed from the 401(k) plan — as long as the person waits until age 59-and-a-half before taking a distribution. By choosing a Roth account, you are opting to pay taxes today and to avoid taxes when you reach retirement age.

Both pre-tax traditional and after-tax Roth contributions to a 401(k) plan offer tax advantages compared to regular investment accounts. That’s because you are not immediately taxed on any capital gains or dividends/interest income generated inside the 401(k) plan as your savings grow.

Which is better: Pre-tax Traditional or After-tax Roth contributions?

Your likely question at this point is: “which is better, Traditional or Roth?”

The theoretical answer is that choosing a Traditional or Roth 401(k) will result in the same amount of money available to you in retirement.

This answer though is making the assumption that the tax rate you face today will be the same tax rate you face in retirement.

Let’s look at a quick example to illustrate this.

If you are at a 30% tax rate, and contributing $1,000 to a Traditional 401(k), the equivalent contribution after-tax would be $700 to a Roth. These would both be invested in identical assets, so the Traditional 401(k) will reach a much larger number than the Roth. For instance, if we assume a 7% return compounded for 30 years, the Traditional 401(k) account balance will be $7,612 while the Roth 401(k) will only be $5,329.

But, remember, you are taxed as the funds are withdrawn from the Traditional 401(k), whereas the Roth account can be accessed tax free. So, if we apply the same 30% tax rate to the Traditional 401(k) balance of $7,612, we see we end up at the exact same amount, $5,329, as the account balance for the Roth 401(k).

Theory Doesn’t Match Reality Though

For most of our clients, younger professionals in the earlier stages of their careers, this example does not align with reality.

First, the assumption that their tax rate in retirement will be the same as their tax rate now is impossible to know. What we do know are tax rates are a function of 1) your earned income and 2) tax legislation passed by Congress.

Since our clients are often in the beginning stages of their career, they believe their income is lower now than what it will be in retirement. They will have accumulated enough assets that their income, as measured from all sources such as dividends, rental income, etc., will be higher than their total income today.

While we don’t take a position or pretend to know where tax law will be in thirty years, some clients are also concerned that they might be much higher. Especially given the recent Tax Cut and Jobs Act passed in December 2017 gives a tax break for most people today, it is even more reason for them to take advantage of the Roth vehicle so as to pay their taxes now rather than in the future.

Second, many of our clients are able to contribute the maximum $18,500 to their 401(k) accounts. This maximum is the same regardless of whether you pick to use a Traditional or 401(k). That means, if you do the maximum contribution to a Traditional account, your take-home pay on each paycheck will be slightly higher than if you had chosen the Roth account. Now, of course, the $18,500 will grow to the same amount for the Traditional and Roth, but the account balance in the Traditional 401(k) has yet to be taxed.

So, to have the same amount of money for retirement, you need to invest the tax savings, that higher take-home pay that you see in each paycheck, into an investment account in order to be equivalent to the Roth option. For many of our clients, investing that additional pay is not an easy exercise. So, from that perspective, the Roth might be preferable as it serves as a form of higher “forced” savings.

Mix-and-Match: Pre-tax and Roth Contributions

Some clients prefer to fund their 401(k) with a mix of pre-tax and after-tax contributions. The advantage here is that the client is still getting some benefit now from the tax savings of pre-tax contributions, and some benefit later on the tax savings of Roth contributions. From a tax diversification perspective, allocating at least part of your contribution to a Roth balances out your retirement vehicles and diversifies you against changes to your tax rate.

For clients receiving employer match contributions, these will be allocated to your Traditional 401(k) account already. This is regardless of whether your personal contributions are going into the Roth portion of the plan. For clients that are fortunate enough to have their employer offer a matching contribution, tax diversification is one more reason why personal contributions to a Roth might be their best option since the employer contribution will be to their Traditional 401(k).

Additional Advantages of a Roth

This article would not be complete if we did not touch on one other favored attribute of Roth accounts: required minimum distributions.

Normally, people are required to start withdrawing funds from their 401(k) plan no later than April 1 of the year following the year they turn age 70-and-a-half. This rule applies to all 401(k) plans, including plans offering designated Roth accounts.

Sometimes, however, a client might not need the money when they turn 70-and-a-half and might prefer to keep their retirement savings inside their retirement plan. In this situation, clients can roll over funds from the designated Roth account portion of their 401(k) to a Roth IRA. Roth IRAs, unlike Roth 401(k) plans, are not subject to the required minimum distribution rule.

The advantage is that you can leave the money to grow on a tax-deferred basis as long as you want, if you do not have immediate needs for it.

What this means is, by having funds in a Roth IRA, you have additional control over when these funds are taken out of the account. For those that plan to leave money to their heirs, these accounts are very effective vehicles for doing so since they can continually grow tax-free.

Takeaway

Tax optimization isn’t just about taking every deduction when filing. Decisions such as choosing a Traditional or Roth 401(k) are key to tax planning.

And, it doesn’t stop there. If you are contributing the maximum to your 401(k), consider utilizing the Backdoor Roth IRA strategy to get even more money saved tax efficiently for retirement.

If you want assistance deciding what works best for you, our tax advisors are happy to help you weigh your options.

 

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