We work with a lot of retirement plans, and one of the most common questions we get from participants is which plan they should contribute to, the Roth or the Traditional 401(k).
Let’s review the difference between the two options. The Traditional option has been around as long as 401(k)s. With it, you contribute before taxes are taken out; it’s a pre-tax contribution. The funds grow tax free. In the future, when the funds are withdrawn, they’re taxed at the then-prevailing tax rate.
In contrast, a Roth contribution is an after-tax contribution. With this option, the contribution is made after all taxes have been paid. Then, in the future, when funds are withdrawn, there’s no tax to be paid for qualified withdrawals.
A pre-tax contribution is essentially a bet that taxes in the withdrawal phase will be lower, while a post-tax contribution is a bet that taxes will be higher. As to which one you should consider, just figure out when your tax rate will be lower—now or in the future—and make the corresponding type of contribution—which is a lot easier said than done.
One rule of thumb is that the younger you are, the more a Roth contribution makes sense. Salary and compensation usually increase over the course of one’s career, putting one into higher tax rates because of our marginal income tax system, which taxes higher income at higher rates. So, if you expect to have a long career ahead of you, consider making a Roth contribution.
In contrast, the older you are, the easier it is to estimate your income in retirement and, in turn, income tax rates. Someone contributing to a qualified retirement plan at age 63 should have a better estimate of their income at age 66 than someone who is 33. You might think of this as a tipping point, that age when your income in retirement will be lower than it is now. That may be the time to switch to a pre-tax contribution.
One can also consider current income tax rates and where they are in relation to past income tax rates to give one an idea of what tax rates could be. Right now, in 2021, income tax rates are about the lowest they’ve been since the end of World War II. On top of that, our national debt continues to grow, which suggests that tax rates will have to go up to service that debt in the future, although there is no guarantee that will be through the income tax system.
If you don’t know what your income tax rate will be in the future—I sure don’t, why not consider making both types of contributions? Call this the-future’s-uncertain strategy. With this strategy, one aims to have both pre-tax and after-tax (Roth) funds in retirement. That way, regardless of what tax rate you face in retirement, you have options. Tax rates higher than you expected, you have the after-tax funds to draw from; tax rates lower? one has the pre-tax funds to draw from.
Furthermore, if your employer offers a match, as of 2021 that match is a pre-tax contribution. So, if your employer matches 80% of your contribution up to 5%, you’re part way to my proposed strategy above. In this example, a 5% after-tax, or Roth, contribution is matched with a 4% pre-tax contribution and—voila—you’ve got the-future-is-uncertain strategy; money ends up in both categories. Then, as you progress in your career, you can consider increasing the pre-tax contribution.
Roth Contributions also mean you are saving more for retirement because the $100,000 in Roth funds is all your money, whereas the IRS will get a portion of the $100,000 pre-tax contribution.
There are also no Required Minimum Distributions for Roth IRAs. With a traditional IRA, you may be forced to take more money out of your accounts than you want to.
Finally, your heirs will inherit Roth accounts tax free. If they’re in a higher tax bracket, it’s a good way to pass along generational wealth.
I hope that’s helpful. If you have more questions, call us or shoot us an email.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
There can be no guarantee that strategies promoted will be successful and no guarantee of positive results.
The investment strategies mentioned here may not be suitable for everyone.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.