Does the Roth 401(k) Alternative Make Sense for You?

How to Make the Roth vs. Pre-Tax 401(k) Decision

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Should you make Roth deferrals or traditional, pre-tax contributions into a 401(k) plan? It's an important question that could have major tax implications. More importantly, choosing the right retirement savings option based on where you stand today and your projected financial situation can help you make the most of your hard earned savings.

The number of employers offering a Roth option in their retirement plan has grown considerably in recent years. The Roth option allows you to contribute money to a retirement plan on an after-tax basis. Like contributions to a Roth IRA, contributions to a Roth 401(k) are not tax-deductible. Rather than benefit from the upfront tax savings through making traditional pre-tax contributions, the tax breaks come later when you begin taking distributions from the plan. Roth accounts allow you to withdraw the earnings growth in your account tax-free as long as the account has been open at least 5 years and you are over age 59 1/2.

Other than the big after-tax difference, Roth 401(k)s work a lot like regular 401(k)s. One similarity is that both pre-tax and Roth 401(k) contributions are eligible for a company match. Whether or not you receive a matching contribution from your company is determined by your employer. If you receive one, it is made pre-tax and is held separately from your Roth 401(k). If decide to leave your employer, you may have the choice to keep your Roth 401(k) where it is or move it into your new employer’s plan if a Roth 401(k) is offered there. Another option is to move it into a rollover Roth IRA, where you will be subject to the same withdrawal rules.

Here are some important questions to consider when determining if a Roth 401(k) makes sense for you:

Can you contribute to a Roth 401(k)?

In order to participate, you must first confirm that a Roth 401(k) is offered by your employer. If it is and you’re eligible to participate, you can contribute regardless of income. Roth 401(k)s are not subject to income restrictions. A Roth IRA on the other hand has income limits which determine if you can contribute. 

How much can you contribute?

The total IRS limit for employee traditional and Roth 401(k) contributions is $18,500 ($24,500 if you’re over age 50 this year) for 2018. 

The pre-tax vs. Roth 401(k) decision does not have to be an either-or scenario. You can contribute to both types of accounts (if provided by your employer). It is possible to make contributions to both a pre-tax and Roth 401(k) as long as your combined contributions do not exceed the annual limit.

Do you anticipate being in a higher tax bracket during your retirement years?

The biggest difference between the pre-tax and Roth 401(k) is whether you pay taxes now as is the case with the Roth or at the time you withdraw the money (pre-tax 401k). Choosing the Roth 401(k) option can be particularly beneficial if you're concerned about being in a higher tax bracket during your retirement years.

Paying taxes upfront also has its benefits if you have a long future of investment earnings ahead of you. Generally speaking, the longer your investment time horizon the greater your potential tax savings. The Roth 401(k) could be most beneficial for someone who is in the early stages of their career and expects their income to rise significantly over their lifetime. The Roth 401(k) could also be a good idea if you're worried that even if your income doesn’t go up in retirement, tax rates might. In fact, the recent Tax Cuts and Jobs Act of 2017 lowered the marginal income tax brackets for the majority of people leaving some to believe they will be higher in future years.

On the other hand, you will likely be better off sticking with the pre-tax 401(k) if you believe your income tax rate will generally be lower when you need the money during retirement. That is because contributions made with pre-tax income provide a current tax year deduction for the amount contributed. Most retirees actually end up finding out they have a lower income replacement rate during their retirement years. In fact, a general guideline is to replace approximately 80 percent of your income to maintain your same comfortable lifestyle during retirement. These lower income levels and the fact that some income sources such as Social Security are only partially taxable provide an additional argument on behalf of the pre-tax 401(k) option.

In simple terms, here is the main difference between the traditional and Roth 401(k):

The pre-tax” 401(k) options gives you a tax break today and requires you to pay income taxes when you take distributions (tax later).
Roth 401(k)s contributions are made with after-tax dollars but give you an opportunity to tax-free distributions (tax now).

Are you planning on using a portion of your retirement savings for wealth transfer purposes?

Roth 401(k) accounts also make sense as a wealth transfer vehicle. One estate planning strategy is to use Roth 401(k) accounts to transfer retirement assets to heirs on a tax-free basis. Inherited Roth 401(k)s are still not subject to income taxes because contributions were already taxed. They are subject to required minimum distribution rules. During your lifetime you can rollover a Roth 401(k) to a Roth IRA to avoid required minimum distributions. This strategy can help preserve assets for heirs and allow for continued tax-free growth.

The Deciding Factor

The biggest factor when deciding if the Roth 401(k) makes sense for you usually comes down to income tax rates. But other variables need to be considered when you make your decision. Your age, current and future tax status, and overall tax diversification between pre-tax accounts (401(k), IRAs, HSAs), Roth accounts, and taxable accounts.