Updated: Feb 27, 2022
In a defined contribution 401(k) or 403(b) plan, a participant typically has the option to make contributions on a pre-tax basis. One of the upcoming trends is a 401(k) plan that offers participants after-tax Roth contributions inside of the retirement plan. If your retirement plan allows for Roth 401(k) contributions and pretax deferrals, how do you decide which option is best?
Both options result in taxes, however the difference is when the tax is paid. The Roth option requires you to pay ordinary income tax in the year those funds were earned. Pre-tax deferrals allow you to delay taxation until a non-rollover distribution occurs. Saving in a Roth 401(k) allows for company contributions to still be made to your account, and Loan provisions are typically still the same as the pre-tax option. The deciding factor then is whether you believe your tax bracket to be lower in the year you earn the funds or when you distribute them in the future. To summarize:
For pre-tax 401(k) contributions:
Taxes are deferred until the funds are withdrawn by means other than a qualifying rollover.
The portion of the contribution, which would be taxable under the Roth option, enters the plan and begins earning dollars sooner.
All earnings are taxable at the date of distribution.
If no withdrawals are made, they become mandatory at age 70 ½ as required minimum distributions. These distributions are included as ordinary income, which could reduce benefits from Social Security and Medicaid.
For Roth 401(k) contributions:
Taxes are withheld and paid on contributions as normal income in the year earned and at the participant’s current effective income tax rate.
Future withdrawals and ALL related earnings are tax-free assuming:
the funds are not distributed within the 5-year participation period [must have a qualified Roth account for 5 years], and
the funds are not distributed prematurely or through a hardship withdrawal.
Required minimum distributions are required as with the traditional pre-tax 401(k), but they are not taxable. Therefore, they will NOT reduce benefits from Social Security and Medicaid.
Roth 401(k) funds may be transferred to a Roth IRA to eliminate applicable minimum distribution requirements in a 401k.
How to Decide
Deciding on which route to go is difficult. There are so many variables to compare that it can make your head spin. Here is a scenario that may provide some guidance for your unique situation:
Person A and Person B (both making $50,000 per year) defer 5% into a retirement plan offered by their employer. Person A chooses the traditional 401(k) and Person B chooses the Roth 401(k) contribution option. The same amount of money goes into the account in either option as deferrals under both methods stem from GROSS compensation.
Today: When each person contributes to their respective plans through their paychecks, Person B’s paycheck will be smaller because the contribution is taxable as ordinary income immediately. Person A does not pay tax on the amount of the contribution to the traditional 401(k) which results in more take home pay.
In retirement: Person A, who contributed to the traditional 401(k), has a tax liability and will receive less benefit from Social Security and Medicaid. Person B’s Roth account will have tax-free contributions and earnings that will not impact retirement benefits like Social Security and Medicaid.
Therefore, a Roth strategy is most beneficial for a person who:
is currently in a lower tax bracket but...
anticipates moving to a higher tax bracket upon retirement...
and can afford a smaller paycheck and...
loves the idea of tax-free earnings and better retirement benefits (if they are still available).
The traditional pre-tax strategy is most beneficial for a person who:
is currently in a high tax bracket and needs to reduce taxable income now
anticipates moving to a lower tax bracket upon retirement
wants to save for retirement but cannot pay the taxes now
and believes more money and less tax today is best.
Other options: Some retirement plan participants may not wish to choose either strategy exclusively, so they may choose to contribute both pre-tax AND Roth funds. Many retirement plans can adopt, or may already allow for, a Roth conversion feature, which enables a participant to convert pre-tax funds to Roth and pay income tax in the year of conversion. This feature can be advantageous in tax years where a participant has excess tax credits that are non-refundable or would otherwise be wasted.
This scenario is simple and excludes a number of more complex factors, such as regulatory changes like the CARES Act and the Tax Cuts and Jobs Act (TCJA). The intent, however, is to demonstrate that a Roth strategy is not exclusive to a particular situation or demographic. Given all the changes impacting our world, perhaps our retirement strategies should change too…
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