By Gavin DiStasi, CES
With the rise of the 401(k) plan as the primary retirement savings vehicle for American workers has come a significant increase in the number of plans offering a Roth 401(k) feature. This is generally a good thing, as it offers workers more options for tax treatment of their deferrals both at the time they are made and when they are eventually withdrawn in retirement. But choices often result in confusion for workers trying to wade through their options, particularly without the help of professional advice, and confusion can often lead to inaction, which is the worst-case scenario of all for savers.
Unsurprisingly, we are often asked the question, should I save into the traditional 401(k) or the Roth 401(k)? It is important, therefore, to fully understand the distinction between the traditional 401(k) side of a plan and the Roth 401(k) side of a plan, which basically comes down to how the contributions and subsequent withdrawals are taxed.
Traditional 401(k) Plan
In a traditional 401(k) plan, participants contribute on a pre-tax basis, meaning the money comes out of their paychecks before taxes are taken out, effectively reducing their taxable income. The money grows tax-deferred along the way, and as long as it remains in the plan until age 59.5 or later, it is taxed at ordinary income tax rates when withdrawn in retirement. With some exceptions (depending on specific plan rules), if the funds are withdrawn prior to age 59.5, an early withdrawal penalty of 10% is likely to be assessed, in addition to ordinary income tax.
Roth 401(k) Plan
On the Roth 401(k) side, contributions are taken out after taxes, which does not reduce current taxable income. The money also grows tax-deferred along the way, and as long as the funds remain in the plan until age 59.5 or later, they can be withdrawn tax-free in retirement. Because the contributions are made after-tax, the rules for withdrawals are more lenient. Assuming the plan allows for withdrawals, in most cases you will not owe taxes or penalties on the amount you contributed, but you will owe them on the portion that represents interest and earnings. (For related reading, see: What Are the Roth 401(k) Withdrawal Rules?)
For years, the conventional wisdom has held that average workers will be in a lower tax bracket in retirement, once they no longer have the income from their job coming in. As such, it was generally assumed that getting a tax break now (presumably while in a higher tax bracket) and paying the taxes later (presumably while in a lower tax bracket) was the better option. There are a few problems with this rule-of-thumb, however.
Why You May Not Be in a Lower Tax Bracket During Retirement
First, it assumes that tax rates will not change over the life of the worker. As advisors, we generally try to avoid the trap of guessing what will happen with policy in the future, and focus instead on the rules as they currently exist. It is noteworthy, however, that tax rates in the U.S. have never been lower, and despite the promises of the current administration and what might happen in the short-run, it’s hard to believe that tax rates are not destined to rise, at least at some time in the future. The point is that it is an uncertain road to assume where tax rates will be many years from now.
Second, the assumption that workers will no longer have the income associated with their jobs may need to be re-thought. With the rapid increase of life expectancies and the need for sustaining ever-longer retirements, it is becoming more and more commonplace for workers to not only continue working past traditional retirement age, but also to continue with some type of gainful employment well into their retirement years. Thus, more and more retirees are likely to have some employment income coming in while potentially taking distributions from their plans, which means they might not be in a much lower tax bracket after all. (For related reading, see: Impact of Continuing to Work in Retirement.)
In addition, because more workers now understand the need to save for longer retirements, many are starting to save early on. This is great, since obviously the younger they start the more they’ll have, but it also means that they might not be at the peak of their earnings potential. As such, they may be in a lower tax bracket now, thus not getting much benefit from the current tax break of saving into the traditional side of their 401(k). In those cases, it might make sense to start out saving more on the Roth side, then moving towards the traditional side once their earnings increase to the point of pushing them into higher tax brackets.
When weighing the decision to contribute to the traditional 401(k) side or the Roth 401(k) side of a workplace retirement plan, it is important to remember that the key to that decision really comes down to when to pay taxes—now (Roth side) or later (traditional side). We often talk to our clients about the importance of tax flexibility in retirement. Having money available in all three of the tax buckets—taxable at ordinary income rates, taxable at capital gains rates and tax-free—gives them the most options for withdrawals. Because of the uncertainly in policy and each worker’s future, this kind of flexibility will allow them to take full advantage of the rules in place when the time comes. That way, once they reach retirement, they can take withdrawals in a way that maximizes their tax savings, no matter how tax laws change or what personal brackets they end up in.
So, for most, the answer to the question, should I save into a traditional 401(k) or Roth 401(k), is likely to be both.
(For related reading, see: 401(k) Plans: Roth or Regular?)
This article was originally published on Investopedia.