Since 1978, many large employers offer a 401(k) retirement program allowing their employees to save for retirement with pre-tax income contributions. In 2006, Congress passed legislation that allowed employees to make post-tax contributions with a Roth 401(k) account. While Roth 401(k)s are still relatively new, employers are increasingly offering both retirement savings accounts. Because of the dual offerings, employees are having to make a decision. Should you split your contributions between both types of accounts or only contribute to one account?
Differences Between A Traditional & Roth 401(k)
Traditional and Roth 401(k) contributions are similar to their Individual Retirement Account (IRA) cousins. You do not pay yearly taxes while the money is in the retirement account. But you do have to pay taxes on the appreciation when the money is withdrawn.
American workers that are currently retired or recently retired only had one option for an employer-sponsored retirement account with tax benefits. That option was the traditional 401(k) where a specified amount of each paycheck was put into an investment account and allowed to grow tax-deferred.
With a traditional 401(k), you do not immediately pay income taxes on the money contributed but the appropriate taxes when the money is withdrawn in retirement. For young employees, that could mean 30 years before they pay taxes on contributions made today.
A Roth 401(k), an employer-sponsored version of a Roth IRA, is funded with post-tax contributions. This means that the worker has income taxes deducted from their income. The employer then puts the contribution money in the Roth 401(k) account after Uncle Sam takes his portion. Since the employee paid taxes on the contribution before it went into the Roth account, he will be able to withdraw it tax-free in retirement.
If an employer makes matching contributions to Roth 401(k) accounts, those are taxed at the time of withdrawal. This is because they are not taxed when the contribution is made. Roth 401(k) contributions cannot be rolled over into a Traditional 401(k) account. With both retirement accounts, all contributions are only taxed once. It just depends on when you want to pay the tax, now or later.
Pre-Tax or Post-Tax Contributions?
There are several factors to consider when deciding which plan will allow you to pay the lowest amount of taxes. Your investments will grow the same whether you choose a traditional or Roth account, but similar to operating fees that mutual funds & ETFs charge, you want to choose the account that will allow you to keep the most of your savings.
Here are several factors to consider:
Future Tax Bracket
Ask yourself, “Will I be in a higher or lower tax bracket in retirement than I currently am in?” This can be very hard to accurately estimate, especially for a 21-year old who only graduated a month or two ago. Lives can greatly change in five years, let alone several decades.
Typically, if you plan on being in a higher tax rate at retirement, the Roth 401(k) will be a better option. You pay the lower tax rate today to avoid the higher tax rate tomorrow. Traditional 401(k)s are good for those that will be in a lower tax bracket than their current tax bracket during retirement.
Although retirement expenses can be hard to predict, large withdrawals from a traditional tax-deferred account can place you in a higher tax bracket. This can possibly be high enough that a Roth would have been more advantageous because of the “upgrade.”
Current Financial Needs
Do you need a tax break now or later? The beauty of traditional 401(k)s is that your taxable income is lower for the current tax year. If you anticipate a large tax bill due next April 15th, a traditional 401(k) or traditional IRA contribution is a good way to reduce your tax burden. The short-term benefits of a lower tax burden can be beneficial if you are trying to pay off debt and have a low take-home pay.
Many employers will match employee 401(k) contributions to a specified dollar amount. They should be able to match contributions to either type of account as all employer contributions have a deferment opportunity. However, they might only contribute to a traditional account because of the additional paperwork burden if they split contributions between both accounts. If they only contribute to one type of account, enroll in this account to maximize the match. If you plan to contribute beyond the employer match, you can put the additional money in either account.
“Taxes Will Only Go Up”
A line that pro-Roth advocates like to mention is that tax rates are more likely to increase than decrease. This is especially notable given the looming federal, state, and local budget deficits. Nobody can predict what the tax brackets will look like in the future. With a traditional 401(k), you take the gamble that withholding percentages will be similar at retirement to what they are now. Future tax rates are more predictable for a 50-year old compared to a 20-year old.
Ask Your Relatives or Friends
Ask people who have recently retired or are near retirement whether they would choose a Traditional or Roth retirement account if they were a young worker. As Roth IRAs and Roth 401(k)s are newcomers to the retirement account scene, they didn’t have the choice (or tax savings potential) that Millennials & Generation X workers have when it comes to retirement savings. They should also be able to tell you what they pay in taxes from their own 401(k) withdrawals.
Split The Contributions
Most employers will allow employees to contribute to both a Traditional & Roth 401(k) account at the same time. Contributing to both accounts is a tax-hedge strategy. If you end up in a lower tax rate at a retirement, you will benefit from the partial Traditional 401(k) contribution. But the bigger payoff might be if you end up retiring in a higher tax rate. Partial Roth contributions will be better than 100% Traditional 401(k) contributions.
How the contributions are allocated can differ for each person. Advice from a financial or tax consultant can greatly help. One can decide to have a 50/50 mix, 80% Roth/20% Traditional, 70% Traditional/30% Roth, etc. Plus, the allocation can be periodically adjusted.
What if I can only contribute to one plan at a time?
If an employer only permits you to contribute to one plan at a time, consider the factors above and your current tax situation. You can always contribute to a Roth 401(k) this year. Then you may decide that a Traditional account is more advantageous the next two years. The important thing is that any saving for retirement is better than nothing at all.
Also, no law or person is prohibiting anybody from investing in a retirement account separate from an employer’s 401(k) plan. You can reduce your contribution levels to the 401(k) and contribute the difference to a Traditional or Roth IRA. There are small differences regarding contribution limits and withdrawal schedules between 401(k)s and IRAs. But this method is an easy way to still take advantage of tax-advantaged retirement accounts.
Opening an IRA at a different brokerage than the 401(k) brokerage also gives you access to more funds. Some 401(k) plans have a very limited selection of available funds that might have high fees or underperform the broad market. If that is the case, contribute enough to receive the full employer 401(k) match and invest the rest in an IRA.
Who Benefits From A Traditional 401(k)
A traditional 401(k) is best for those that expect to be in a lower tax bracket than their current tax bracket, even after withdrawals. A traditional 401(k) also provides immediate tax relief which can be beneficial for short-term financial needs. But addressing short-term needs can reduce long-term tax savings.
Who Benefits From A Roth 401(k)
The most obvious advantage of a Roth 401(k) is that the tax bill is paid upfront. For young people, this can be very beneficial. They generally make less than their older superiors and their contributions have 30+ years to appreciate in value. As investing advocates usually talk about the magic of compound interest, chances are that contribution will be larger than it’s initial size.
This means the tax rate will probably be higher. Besides 20-year-olds, even workers in their 40s and 50s can benefit from post-tax contributions. If nothing else, Roth gives people peace of mind. They do not need to set aside a portion of each withdrawal to pay taxes (minus employer contributions).
The important thing to remember is that it is important to save for retirement regardless of the account type. Contributions to either type of 401(k) mean that you will pay fewer taxes than if the money was in a normal, taxable investment account. Plus, you can start investing with as little 1%!