When Does It Make Sense to Contribute to a Roth 401(k)?

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

Choosing the right path can be complex with the Roth vs. Pre-Tax 401(k) decision. Creative RF/RubberBall Productions/Getty Images

Saving for retirement is an important step to take on the path to true financial independence. With rising concerns about the future of Social Security and the savings burden being placed on individuals, 401(k) plans have a major impact on future retirement preparedness. Choosing to participate in a retirement plan offered by your employer is an important step to take. But you have another important decision to make after choosing exactly how much you are willing and able to save for the future.

Should you set aside savings in the traditional pre-tax 401(k) or the Roth 401(k)?

If you take some time to understand the differences between a traditional pre-tax and Roth 401(k) you can significantly reduce your total lifetime income taxes. More importantly, you will be taking a proactive step toward planning for your own retirement.

Pay your taxes now or later. Roth 401(k)s allow you to contribute after-tax dollars that can grow to be tax-free after age 59 ½ as long as you’ve had the account for at least 5 years. Choosing whether it makes sense for you to receive the tax savings now or later is a big part of the pre-tax vs. Roth 401(k) decision. Here are some important things to look at if you are trying to decide if contributing to a Roth 401(k) makes for you:

Determine the Type of Plan Your Employer Offers

First, check to see if your employer offers a Roth 401(k). This may seem like a no-brainer, but the Roth 401(k) is relatively new and isn’t offered by all employers.

Approximately 60 percent of large retirement plan sponsors now offer a Roth option. Many employers offer an after-tax 401(k) contribution option but this can differ significantly from an after-tax Roth 401(k) and shouldn’t be confused with a Roth 401(k). If you have a Roth 401(k) available you should also be aware if the Roth account provides the same features as the pre-tax traditional 401(k).

It’s also important to understand how your company matching contributions work (if your employer offers a match). Many employers provide an incentive to participate in a 401(k) plan through matching contributions. You do not want to miss out on maximizing your 401(k) match and if you have a company provided match you will still get the match if you elect to participate in the Roth 401(k). Just keep in mind that if you are participating in a Roth 401(k) the company match is a pre-tax contribution. The matching funds and the investment growth of these company provided funds will be taxed as ordinary income when you begin taking distributions at retirement.

Traditional and Roth 401(k)s: Understanding the Differences

The annual contribution limits for a Roth 401(k) are the same as those for a traditional pre-tax 401(k). In 2016, you can contribute up to $18,000 to a 401(k). If you are age 50 or older, you can contribute an additional $6,000.

The main difference between the Roth and pre-tax traditional 401(k) is how they are taxed. As the name implies, traditional “pre-tax” Traditional 401(k)s help lower your taxes now. However, you will have to pay taxes later when you start taking money out in retirement.

With a Roth 401(k) you are setting aside after-tax dollars that are taxed now but the income tax breaks come later with tax-free withdrawals of investment gains during retirement.

Here is a very simple explanation of the main difference between the traditional and Roth 401(k):

Traditional “pre-tax” 401(k) – You pay income taxes when you take distributions

Roth 401(k) – You pay income taxes on your contributions and can make tax-free distributions

It is also important to note the similarities and differences between a Roth 401(k) and a Roth IRA. Roth 401(k)s and Roth IRAs both offer tax-free growth of investment earnings. However, Roth IRAs are subject to income limitations. For example, in 2016 single individuals with adjusted gross income of more than $132,000 are ineligible for a Roth IRA, as are couples filing jointly making more than $194,000.

Unlike Roth IRAs, your ability to contribute to a Roth 401(k) is not affected by your income level because Roth 401(k)s are not subject to income limitations.

It is possible to contribute to both a Roth 401(k) and a traditional 401(k) as long as your combined contributions do not exceed $18,000 ($24,000 if you are 50 or older) in 2016. A recent study highlighted the benefits of contributing to a combination of traditional and Roth accounts.

401(k) contribution limits in 2016

Will Lowering Your Taxable Income Help You Qualify for Other Tax Breaks?

Most people get a not so peaceful uneasy feeling when the subject of taxes comes up. But it is important to at least have a basic understanding of your income tax situation. A little tax awareness can make a huge difference. In many cases the simple act of lowering your adjusted gross income (AGI) can help you qualify for tax credits and other tax breaks. For example, the retirement savers credit is not available if your AGI is above $61,500 for married couples filing jointly, $46,125 for head of household status, and $30,750 if you are single or married and filing separately. Another example of how lowering taxable income can help you is found with the child tax credit. The child tax credit begins to phase out if your modified adjusted gross income is above $110k for a married couple filing jointly or $75k for a single person. In both of these examples contributing to a pre-tax 401(k) can help you to get more of the credit if your income is slightly above these limits. Paying attention to your adjusted gross income and lowering it when possible can also make you eligible for a deductible IRA or a Roth IRA.

Do You Want to Pay Income Taxes Now or in the Future?

Most of us want to minimize our tax burden as much as possible. Trying to navigate our complicated income tax code in the U.S. can make the Roth vs. pre-tax decision-making process seem a little complicated. But if you break it down to the core it all comes down to whether you want to pay taxes now (Roth) or at the time you withdraw the money (pre-tax). Deciding the best option for you requires a little retirement planning to determine when you think you will be in the highest tax bracket.

If you are in the early stages of your career and are currently in a lower income tax bracket the Roth option seems appealing. You can lock in known income tax rates today that could be lower than your future income tax bracket during retirement when you will need your retirement savings. However, if you are in your peak earning years and nearing retirement it likely makes the most sense to take the tax breaks today with a pre-tax traditional 401(k) contribution. As a result you will benefit from paying income taxes during retirement rather than during your high income earning years immediately prior to leaving the workforce.

Most retirees in this country end up with an income replacement rate during retirement that is lower than their income while working. But if you think your income will actually be higher in retirement, the Roth 401(k) could make more sense. The Roth 401(k) begins to look like a bright idea if you’re worried that even if your income doesn’t go up in retirement, tax rates might be headed higher.

How Good Are You at Predicting the Future?

It can be difficult to make Roth vs. pre-tax 401(k) decision when future income tax rates are uncertain. Instead of relying on a fortune teller or Magic 8 Ball to predict the future try asking yourself these questions to help you decide:

How likely is it that your income will increase between now and retirement? When it comes to personal financial matters we aren’t always that great at predicting the future. It can be even more difficult to predict what Congress will do with tax rates decades from now. That being said, you should seriously income your future earnings potential when making the Roth vs. pre-tax 401(k) decision. If you are at or near your peak earning years right now you may want to stick with pre-tax traditional 401(k) contributions. But if you anticipate your income increasing you will likely see your income tax bracket increase. This could bump you into a higher tax bracket and make the Roth option more appealing.

Do you plan on working during retirement? You may not see any big changes in your income tax bracket if you plan on working into traditional retirement years. The end result of this could keep you in the same tax bracket. Usually if your tax bracket is the same at retirement you will see equal benefits with a Roth compared to a pre-tax 401(k). In this situation, it may help to consider keeping some money in a Roth account to avoid seeing your income taxes creep into a higher marginal tax bracket.

What are the chances that you will be retiring during a period of higher income tax rates? If you are worried about higher taxes across the board in the country as a result of the current political and economic landscape you should consider going with a Roth 401(k). However, it’s important to note that just because income tax rates may increase across the board, that doesn’t necessarily mean your personal tax rate will be higher.

As you can probably tell the Roth vs. pre-tax 401(k) decision is a little more complicated than it seems. Choosing the best account for you depends on a variety of factors such as your expectations about future income tax rates and how much tax diversification you are seeking. Check out this Roth vs. pre-tax calculator if you would like some additional guidance when comparing your options.