Should I Consider Roth Contributions in My Company 401(k)?
When people think of Roth retirement plans, they often think of Roth IRAs – or Individual Retirement Accounts. But employers are increasingly offering their employees Roth 401(k) plans, and these plans have grown in popularity over the years.
According to Aon Hewitt’s study of 3.5 million 401(k) plan participants, 11% contributed to a Roth 401(k) in 2014. The rate of plan participants choosing to contribute to Roth plans in 2011 was 8.1%.
Depending on your needs, you may stand to save on taxes by choosing a Roth 401(k) over a traditional 401(k). The fundamental difference between these two retirement plans is when you pay income taxes on this investment.
Everyone’s situation is unique. While this article provides a general overview, we encourage everyone to consult with your tax advisor before making decisions.
How Does A Roth 401(k) Differ From A Traditional 401(k)?
With a traditional 401(k), you only pay income tax when you withdraw from your account in retirement. Your contributions are made tax free, because your employer sets aside the amount you wish to contribute before they withhold taxes from your paycheck. Because you pay taxes when you withdraw, you wind up paying taxes on the money you initially invest, and on the earnings you made from those investments.
With a Roth 401(k), you contribute funds into your account after you’ve received your paycheck – meaning your employer already withheld income tax. However, you won’t pay any income tax when you withdraw from your savings in retirement. This means that your investment’s earnings will not be taxed when you withdraw in retirement.
With the difference between these retirement plans in mind, there are some questions you should ask that will steer you toward one plan versus the other.
Does Your Company Match Your Contribution?
Many companies offer to match the contributions you make toward retirement (up to a specified percent of your salary). You hardly ever want to leave this free money on the table, but it’s worth noting how your employer’s matching contribution is impacted in traditional and Roth 401(k) plans.
(As an aside, if an employer matches a traditional 401(k) plan, it typically matches a Roth 401(k) as well).
If you choose a Roth 401(k) and your employer matches, the money they contribute is not treated the same as the money you contribute. Your company’s matching contribution is made before they withhold taxes from your paycheck, and into a traditional 401(k). Their initial investment in your account and its earnings are taxed upon withdrawal – unlike the contributions you make.
You can also roll funds from a traditional 401(k) plan to your Roth 401(k) plan. However, you’ll owe income tax on the amount you choose to transfer. The exact amount of tax you owe can be tricky, so you may need to speak with your advisor to calculate the taxes you’d owe. You can estimate the taxes on your conversion by simply applying the rate applied to income in your tax bracket. It’s always wise to consult a tax professional who can answer your questions.
Once you’ve transferred funds from your traditional 401(k) to your Roth 401(k), you cannot transfer them back to a traditional 401(k) plan.
Which Tax Bracket Do You Fall Under?
Choosing between these two types of 401(k) plans ultimately comes down to which plan minimizes the amount of tax you have to pay. And the decision often comes down to identifying when in your life you’ll be in your highest tax bracket. You want to make sure that you won’t pay taxes on your contributions or distributions in that period.
Let us explain with a few examples.
If you’re fairly young – and conceivably in a relatively low tax bracket – you’re likely going to be in a higher tax bracket in retirement. You’ll wind up paying a lower tax rate on the money you invest in a Roth 401(k) now, and you won’t pay any taxes on your withdrawal in retirement – when you’re in a higher tax bracket.
Conversely, if you’re nearing retirement – and conceivably in a relatively high tax bracket – you’ll likely be in a lower tax bracket after you retire. If you choose a traditional 401(k) plan, you won’t pay taxes when you make your contributions – when you’re in a higher tax bracket. Instead, you’ll pay a lower tax rate when you withdraw from your retirement savings.
These examples are very general, of course, and they are scenarios that don’t apply to everyone. But it’s why financial advisers tend to advise their clients to contribute to traditional 401(k) in the years leading up to their retirement. It’s also why they’re inclined to advise that their clients contribute a portion of their income to a Roth 401(k) early in their careers.
Of course, when you contribute to a traditional 401(k), you’re reducing your taxable income, potentially dropping you into a lower tax bracket. Depending on your income level and how close you are to a lower tax bracket, it might make the most sense to contribute enough into a traditional 401(k) that you drop into that lower tax bracket, and pay a lower tax rate on the money you contribute to a Roth 401(k).
What Are Your Savings Goals?
How much you intend withdraw from your retirement savings each year also has a significant impact on the decision between a traditional or Roth 401(k) plan. It’s not unreasonable to think that you might want to live lavishly in retirement. And if that’s the case, you’d withdraw more money each year and put yourself in a higher tax bracket. This conversation all stems from your savings goals.
But today, most people want to learn how to manage their investments and money at every stage of their life, not just their retirement. It requires you to align your money with a specific purpose, rather than saving for the sake of saving.
In a previous article, we discussed the importance of beginning the planning process with a discussion about your next stage of life, whether it includes saving for caregiving and support or renovating your home. Retirement planning is no longer about reaching your “big number” – it’s about strategically planning for longevity and how your funds will impact your lifestyle and loved ones.
With that in mind, a Roth 401(k) could certainly be a means to planning for your retirement. But by this point, hopefully it’s clear that whether or not a Roth 401(k) is the right move for you depends on your situation and needs.
If you’d like support in making this decision and have some specific questions, you can always get a second opinion.
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About Greg Hammond, CFP®, CPA
Greg Hammond is the chief executive officer of Hammond Iles Wealth Advisors, and co-founder of Planned Giving Strategies®. Greg leads a team of professional financial advisors providing customized wealth management and investment solutions for high-net-worth individuals, families, companies, and charitable organizations across the U.S.