Since many employers are now offering a Roth 401(k) option, employees should consider the potential benefits of contributing to the Roth option instead of a traditional 401(k).
Much like a Roth IRA, a Roth 401(k) can provide tax-free income during retirement; however, employees make contributions with after-tax dollars compared to contributing to a traditional 401(k) with pre-tax dollars. The tax treatment of 401(k) options is designed to be tax-neutral so that results would essentially be the same for a Roth 401(k) and a traditional 401(k) for individuals who have the same effective tax-rate when making contributions as they do when distributions are taken.
Choosing Between a Traditional and Roth 401(k)
Determining if a Roth 401(k) is the right strategy depends on two primary factors: the applicable tax rate now and expected tax rate in the future.
The current applicable tax rate is essential because contributions to a Roth 401(k) are subject to taxes on the amount being deferred. If the same amount was going into a traditional 401(k) account, it would avoid current tax. If current tax rates are high, there is value in deferring tax on income by using a traditional 401(k); however, the benefit of deferring tax on contributions is reduced or eliminated if current tax rates are lower now than expected tax rates in retirement.
A traditional 401(k) plan is likely the best option for employees who anticipate that their tax rate in retirement is going to be lower than their current tax rate today since they are deferring income at one rate and then paying tax at a lower rate in the future.
On the other hand, if an employee anticipates higher taxes in the future, then the Roth 401(k) may make more sense because it allows individuals to pay taxes today at a lower rate and then later withdraw those funds tax-free.
Roth 401(k) Benefits
Since many employees expect to have a lower tax rate in retirement, maximizing pre-tax contributions to a traditional 401(k) makes sense; however, this strategy fails to consider the following benefits of a Roth 401(k):
- Employees starting their careers can take advantage of the Roth option when income is lower and receive potential benefits of tax-free compounding for many years.
- Since the ability to contribute to a Roth IRA is subject to income limitations, higher wage earners can use a Roth 401(k) option to fund a Roth account. When retiring (or leaving a job), individuals can roll over money from a Roth 401(k) directly to a Roth IRA. Rolling a Roth 401(k) to a Roth IRA eliminates required minimum distributions (RMDs) after age 70 ½ that individuals with Traditional IRAs are subject to. RMD requirements may be higher than what is required to fund retirement needs, and a Roth IRA provides flexibility to take distributions when needed without incurring income tax.
- Employees who roll money directly from a Roth 401(k) plan to a Roth IRA when leaving a job, can take advantage of other Roth IRA benefits. If the Roth IRA has been in place for at least 5-years, an owner can withdraw their contributions tax-free and avoid the 10% early withdrawal penalty that applies to distributions before age 59 1/2. It is important to remember that withdrawals of account growth before age 59 1/2 from a Roth IRA are subject to income tax and penalties.
- Roth IRAs also offer an ability for first-time home-buyers to withdraw up to $10,000 tax and penalty free toward a home purchase.
- Since current tax rates are relatively low by historical standards, contributing to a Roth 401(k) option can provide a tax-diversification strategy to mitigate risks of tax rate increases in the future.
- Distributions from a Roth IRA are not taxable income and do not impact Medicare Part B premiums in retirement. Premiums for Medicare Part B currently range from a minimum of $135.50 per month to a maximum of $460.50 per month based on taxable income as of 2019.
- The House Ways and Means Committee recently passed the Setting Every Community Up for Retirement Enhancement Act of 2019 (the SECURE Act) which has bi-partisan support. The proposed bill includes measures which would require beneficiaries (other than a surviving spouse, disabled or chronically ill, or individuals who are not 10-years younger than the original account owner) to distribute IRA assets within 10-years. Current rules allow the option to “stretch” distributions over beneficiary’s lifetime which allows more time for tax deferred growth of the IRA. Should this bill become law, the Roth IRA would represent a more attractive option for passing wealth to younger descendants since distributions would be tax-free.
Determining an optimal retirement savings strategy should be based on an individual’s circumstances and financial goals. Working with a qualified financial planning professional who uses cash-flow based retirement planning to consider a variety of factors that impact results can help you develop a roadmap to achieve financial freedom.