When is $1,000,000 not really $1,000,000? When it’s in a traditional 401(k) plan.
The most common workplace retirement account for American workers is the traditional 401(k) plan, which, as with most retirement vehicles, provides an immediate tax break to the saver. Roth 401(k)s are similar to a traditional 401(k) plan except that contributions to the Roth plan go in after-tax, and withdrawals in retirement are tax-free.
Here’s what you need to know about how a Roth 401(k) is different from a traditional plan, the important benefits of a Roth 401(k), some scenarios when it makes sense to contribute to a Roth 401(k) and when it doesn’t.
How a traditional 401(k) plan differs from a Roth 401(k)
With a traditional 401(k) plan, if you’re in the 24% federal tax bracket, every dollar you contribute effectively saves you 24 cents on your taxes in the current year. On top of that, you save state taxes as well.
The downside to traditional 401(k) savings is that you’ll pay income taxes eventually, likely when you start drawing down on the account during retirement. So if you save $1,000,000 during your career, and all of it is in a 401(k), you’ll still owe income taxes upon withdrawal. That million dollars may be worth considerably less once you account for state and local taxes.
So when is $1,000,000 in retirement actually $1,000,000 for you to spend? If it’s in a Roth 401(k) plan.
The Roth 401(k) plan works the opposite of the traditional. You get no income tax break upon contribution. Sorry, no savings (today) for you. But, you’ll get the same tax deferral during the years the money is invested. And, assuming you’re age 59½ or older when you withdraw from your plan, you will owe no taxes upon withdrawal of your funds. You actually get to spend the full $1,000,000 you see as your account balance.
If you have a Roth 401(k) available to you through your employer, it’s worth a long look. The Roth 401(k) offers a much higher annual contribution limit than the Roth IRA ($19,500 for the 401(k) in 2020 vs. $6,000 for a Roth IRA). More importantly for high earners, the Roth 401(k) isn’t subject to the same income limits that restrict many people from being able to contribute to a Roth IRA.
Here are the major differences between a traditional 401(k) and a Roth 401(k):
|Traditional 401(k)||Roth 401(k)|
|Contribution tax treatment||Contributions are made pre-tax and reduce your adjusted gross income.||Contributions are made after taxes and don’t affect your adjusted gross income.|
|Withdrawal tax treatment||Distributions in retirement are taxed as ordinary income.||Distributions in retirement are generally tax-free.|
|Withdrawal rules||Withdrawals of contributions and earnings are taxed.||Withdrawals of contributions and earnings are not taxed as long as the distribution is considered qualified* by the IRS.|
*In order to be considered qualified, your account must be held for at least five years and you must be at least 59 ½ or the distribution must be due to disability or death.
Benefits of a Roth 401(k) plan that beat a traditional 401(k) plan
There are two main benefits that a Roth 401(k) offers that you can’t find in a traditional 401(k) plan:
Practically no Required Minimum Distributions
A traditional 401(k) plan compels that you take Required Minimum Distributions when you reach age 70½ or face severe tax penalties. If your money is in a Roth 401(k) and you no longer work at the organization, you have required minimum distributions. But, you can roll that money into a Roth IRA, and then you no longer are required to take money out.
If you’ve taken advantage of tax diversification and can live on the money you have from other sources (a pension plan, Social Security benefits and pre-tax retirement accounts like a traditional IRA), then the Roth 401(K) can continue growing. The Roth 401(k) could eventually be passed onto your heirs without them owing taxes either. This makes Roth 401(k) money one of the most tax-efficient ways to leave money to your family.
No withdrawal penalties on contributions
We’ve all heard that we shouldn’t plan to take money out of retirement accounts for anything except retirement. But life isn’t always so smooth. Maybe you start a business and need a source of funds. Perhaps you have a significant unexpected expense that goes beyond your emergency fund. Since you have already paid taxes on that money, you can withdraw up to the amount you have contributed (but not earnings) from your Roth 401(k) without penalties or taxes provided the withdrawal is considered qualified by the IRS. “It’s a good ‘last step’ emergency fund,” says Tara Unverzag, a CERTIFIED FINANCIAL PLANNER™ professional at South Bay Financial Partners.
When to consider Roth 401(k) contributions
Roth 401(k) plans were introduced in 2006, and despite being available for more than a decade, are still an under-utilized tool. The following are some scenarios where it makes sense to consider the Roth 401(k):
1. You’re earning much less than you will in the future
Since tax brackets rise with income, it makes sense to pay taxes when you’re in lower earnings years. While not everyone has certainty on future earning potential, if you work a job where you are reasonably sure you’ll be making far more in the future, it may make sense to pay taxes at a lower rate now than in the future.
As an example, a young engineer who starts their first job may make $100,000 to $120,000 per year. Within a decade, many people in this field are earning well over $200,000, and often more than that. By putting money into their Roth 401(k) early in their career, they paid taxes on that money while in a lower tax bracket than they may be in for decades to come. Similarly, many young doctors also, particularly during residency, can benefit from putting money aside and paying 10% or 12% in taxes, whereas their future earnings could potentially have them well into the 30%-plus tax bracket.
“Another scenario would include when a spouse takes a break from earned income to stay home with kids and has plans to re-enter the workforce later,” says Wakefield Hare, a CFP® professional at Greater Than Financial. Taking one income out of a family’s plan will likely affect which tax bracket they fall into, and odds are it’ll mean they are in a much lower one than they will be upon becoming a two-income family again.”
2. Your other retirement money is all in pre-tax accounts
There’s a lot of talk amongst financial planners about diversification in terms of types of investments. There’s not as much talk about diversification amongst the tax treatment of your account types.
Take a married couple where one works for a private company and the other is a public school teacher. The public school teacher will have a pension, and that pension will be pre-tax, so you’ll end up paying taxes on that income during retirement. You’ll each have social security, which is also (mostly) treated as taxable income for many higher income earners. Utilizing a Roth 401(k) helps you diversify your retirement savings, so you can tap into that bucket without triggering income taxes. This is especially helpful if you’re navigating income cliffs for various benefits, and may need to get cash flow into your hands without increasing your taxable income and eliminating a benefit you may otherwise be eligible for.
3. You’re beyond the income limit for Roth IRAs
In 2019, if a couple earns more than $203,000, they’re not able to contribute to Roth IRA’s, so this allows them to get money in a post-tax bucket that may otherwise be unavailable. “Some clients may be uncomfortable navigating a backdoor Roth IRA if they are income phased out, so contributing to a Roth 401(k) can be a nice alternative,” says Riley Poppy, CFP® professional and founder of Seattle based Ignite Financial Planning.
4. You want the psychological benefit of your Roth 401(k) nest egg in tax-free
Going back to the initial premise of the article, the total value of your Roth 401(k) (and Roth IRA) is yours. No taxes. Ever again. There is a huge psychological benefit if you’re able to get your current self to take a smaller hit (no tax break) now in order for your future self to benefit from getting to use that full value of your account.
When to consider traditional 401(k) contributions
A traditional 401(k) offers plenty of advantages to retirement savers. Here are two scenarios that work well with this retirement plan:
1. Your earnings significantly outpace your spending
Say you’re a married couple and earn $350,000 annually, but live on $60,000 annually. In this case, it’s likely you’ll only need to draw $60,000 (not accounting for taxes) out of your retirement accounts each year. This would place you in the 12% federal tax bracket when withdrawing, but the 32% bracket while earning. In this case, the traditional 401(k) plan may make more sense, since you’ll save 32 cents on the dollar, and would only be subject to 12 cents of tax on every dollar in retirement. It’s hard to project what’s going to happen to tax rates and your income that far into the future, but generally high earners who also have a high savings rate might want to consider maximizing pre-tax savings as much as possible.
2. You are seeking public service loan forgiveness on federal student loans
Every financial decision you make is inter-related. If you’re working towards getting your student loans forgiven, you’re likely on an income-driven plan. In that case, your goal is often to make your adjusted gross income (AGI) as low as possible. “I have several of my clients divert money into their pre-tax 401(k)s as it lowers their AGI which, in turn, can lower their student loan payments,” says Justin Owen, a financial planner with Owen Financial Planning. “This is a good scenario where there is a justifiable benefit in the pre-tax 401(k) over the Roth 401(k).”
Use the workplace retirement plan that works best for you
Personal finance decisions are rarely clear cut, and this is another that falls into the camp of “it depends.”
If you have a Roth 401(k) option available at work, it’s worth considering your future earnings, your other savings vehicles, and your perspective on the future of U.S. tax rates in determining whether or not to use this account.
Ryan Frailich, a CERTIFIED FINANCIAL PLANNER ™ professional, runs Deliberate Finances, a fee-only financial planning firm which specializes in helping young couples and educators plan for their financial lives. When not working, Ryan is exploring New Orleans, running with his dog Dodger, or building block towers with his young son. Opinions are his own. This article is sponsored by Haven Life Insurance Agency.
Haven Life Insurance Agency (Haven Life) does not provide tax, legal or investment advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, or investment advice. You should consult your own tax, legal, and investment advisors before engaging in any transaction.