Introduction
If your company provides both a Roth 401(k) and a Traditional 401 (k) option to you at work, which one should you contribute to? I know most of you would prefer a clear-cut, definitive answer, but unfortunately it’s not quite that easy or straightforward. Rather, the right choice can vary greatly from person to person and depends heavily on the particulars of your personal financial situation.
Below, I will layout the cases for both the Roth 401(k) and the Traditional 401(k) and present the reasons why it might make sense to go with each of the respective options. Hopefully by the end of this article, you will have a better idea of which option is the right choice for you.
Reasons Why Investing in a Roth 401(k) Might Make Sense
If Your Marginal Tax Rates are Lower Now Than They Will be in Retirement
Probably the most important factor in the Roth vs. Traditional 401(k) discussion and a key determinant in which one is right for you is if your marginal tax rate (i.e. the rate at which your last dollar of income is being taxed) is higher or lower now than what it will be in retirement. If you’re in a lower tax bracket right now, but expect yourself to be in a higher tax bracket in retirement, then it might make sense to invest in the Roth 401(k). By getting the taxes out of the way now on the front end, you are paying them at a discount to what your future self will have to pay when in a higher tax bracket.
For example, if you are a doctor that is currently in residency, chances are that you are in a lower tax bracket than you will be when you retire. Thus, it’d probably make sense to use the Roth 401(k) now, while you’re in a lower tax bracket and pay a lower marginal tax rate than your future self will be able to. Similarly, if you and your spouse both normally work, but one of you is currently not working for whatever reason (school, stay at home parent, etc.), then it might make sense to utilize the Roth 401(k) while your income is temporarily diminished.
Tax Diversification for Assets
Your assets can generally be broken down into one of three main categories of money: tax-deferred accounts (Traditional IRA, 401(k)s, etc.), tax-free accounts (Roth IRA, Roth 401(k), possibly HSAs, etc.), and taxable accounts (basically everything else, all of your money that is not in a qualified plan, including savings accounts and brokerage accounts). Think of these three categories as different buckets of money that will be available to you to tap into and receive income from during your retirement years. In order to maximize the options available to you and give you the most flexibility during retirement, it’s important to have some tax diversification with assets spread across all three of these buckets and not just all clumped together in the tax-deferred bucket.
Tax diversification can be a very useful tool in your financial planning toolbelt. Depending on where tax rates are when you retire, by having assets spread across all three buckets, you may be able to reduce your effective tax rate from year to year in retirement. Instead of having to withdraw all living expenses from your tax-deferred bucket, you can withdraw some from your tax-deferred bucket, some from your taxable bucket at more favorable long-term capital gains rates, and withdraw some from your tax-free bucket.
Similarly, let’s say that you have an unusually large expenditure one year during retirement (you take a dream vacation that you’ve always wanted to take, your house needs a new roof, etc.). If you had the majority of your money in tax-deferred accounts, then paying for these expenses could potentially push you into a higher tax bracket than you normally would be. However, if you have some assets available to you in your taxable and tax-free buckets, then you will have more flexibility to navigate higher-than-normal expenses without increasing your effective tax rate.
Therefore, if you have a substantial amount of your investible net worth in tax-deferred accounts, such as IRAs and 401(k)s, then making contributions to a Roth 401(k) will give you more tax diversification across the different buckets later on in life. Similarly, if your employer offers a very generous match (the employer part of 401(k) contributions is pre-tax and will be contributed to a Traditional 401(k) in your name), then it might make sense to make your contributions post-tax into the Roth 401(k) in order to get some tax diversification inside your 401(k).
When it comes to financial planning, I like having options, and by spreading your assets across the different buckets of money, you will be able to create more flexibility and planning opportunities for yourself during retirement.
Historically Low Tax Rates
We are in a historically low income tax environment right now. Just to give you some perspective, below are the income tax brackets for the years 2000 and 2020 respectively.
In the year 2000, a married couple filing jointly with an adjusted gross income of $200,000 would have had a marginal federal income tax rate of 36%, while a married couple filing jointly with the same income today would have a marginal tax rate of 24%. Also note that the standard deduction for a married couple filing jointly was only $7,350 in 2000, versus $24,800 in 2020. Only 20 years difference, but a 50% difference in marginal tax rates!
Now, obviously, a dollar in 2000 is worth more than a dollar in 2020, thanks to our good friend inflation. So, let’s take a look at an inflation-adjusted comparison. A dollar in 2000 is roughly worth a $1.50 today, thus a family making $200,000 in 2000 would be equivalent to making $300,000 today. The family in 2000 still has a 36% marginal tax rate, and the couple today would still have a 24% marginal tax rate!
What’s even crazier is that even a family only making $50,000 ($75,000 inflation-adjusted) in 2000 would be in the 28% federal marginal tax rate, a 4% higher marginal tax rate than a family making $300,000 today!
All this is to just give you some perspective. It’s never fun to be paying taxes, but I’d much rather pay 24% versus 36%. Will we go back to the year 2000 tax levels, or even higher (the top U.S. tax bracket has been as high as 90% in the past)? No one has a crystal ball and can say definitively one way or another, but I’m personally of the opinion that at some point tax rates will have to go back up. Both parties have been running larger and larger deficits over the past couple of decades and at some point I believe that we’ll have to pay the piper and raise taxes again.
Thus, I think that it could make a lot of sense to contribute to a Roth 401k versus a traditional 401(k) and take advantage of these low tax rates while you can.
You Reside in a State with Low to No state Income Taxes
State taxes shouldn’t factor into the equation too much if you’re planning on retiring in the same state where you currently reside (unless you believe tax rates will change substantially in the years to come in your current state). However, if you currently reside in a state with low to no state income tax, but plan on retiring in a state that has a fairly high state income tax, then it might make sense to invest in the Roth 401(k) versus a Traditional 401(k). For instance, let’s say that you currently reside in Florida or Texas (both of which have no state income tax), but your lifelong dream is to live on the West Coast and you want to spend your retirement years in California (which has a 10% state income tax). In that case, it might make sense to invest in a Roth 401(k) instead of a traditional 401(k).
Could potentially Access Contributions Earlier than 59 ½ without Taxes or Penalty
For those of you that are wanting to retire early, by investing in a Roth 401(k) versus Traditional 401(k), you could potentially access contributions in the Roth 401(k) prior to age 59 ½ without taxes or penalty, if you plan appropriately. Please read the following section carefully, so as not to misinterpret what I’m saying.
Unlike a Roth IRA, which permits you to pull all of your contributions out of your account before withdrawing the investment earnings, unqualified Roth 401(k) distributions prior to 59 ½ are prorated between contributions and earnings. The prorated amount withdrawn from investment earnings is subject to both taxes and a 10% penalty. For instance, let’s say that you have contributed $70,000 to a Roth 401(k) and the account has grown by $30,000 and the account is now worth $100,000. In that case, your earnings ratio would be 30% ($30,000/$100,000). For every dollar that is withdrawn from the plan before age 59 ½, you would have taxes and a 10% penalty due on 30 cents on every dollar withdrawn. There is a way around this however.
The IRS permits investors to rollover their Roth 401(k)s to Roth IRA accounts with no taxes or penalty once you have left an employer. If you transfer your Roth 401(k) into an existing Roth IRA account that has been opened and funded for at least 5 tax years, then you can withdraw all contributions tax-free, thus avoiding the Roth 401(k) prorate rules. The key thing to know is that the Roth IRA that you roll the Roth 401(k) into must have been opened and funded with a contribution at least five tax years earlier in order to avoid penalty, so plan accordingly. If you currently have a Roth IRA that you’ve been contributing to or doing backdoor Roth conversions into, these would work great, just don’t move that money to a new Roth account if you’re planning on retiring within 5 years.
If you are planning to retire early, and most of your money is tied up in tax-deferred accounts, contributing to a Roth 401(k) may allow you to access that money with more flexibility and with less hassle than other strategies, such as 72(t) distributions or Roth conversion laddering. If this applies to you, it might make sense to contribute to a Roth 401(k).
You could avoid paying RMDs
In my years as a financial planner, I don’t know of a subject that is uniformly reviled as much as Required Minimum Distributions (RMDs). Retirees hate them. If you have a substantial amount of retirement money in tax-deferred accounts and are not huge spenders, then you might end up having a significant RMD problem down the road where the amount that you have to withdraw each year in order to satisfy the RMD requirement begins to push you up into higher tax brackets.
With careful planning, some of this can be avoided by making annual Roth conversions once in retirement to help curb the size of future RMD withdrawals, but sometimes it may get to the point where your tax-deferred assets get so large that Roth conversions can only do so much to curb your RMDs. This is where a Roth 401(k) might be useful.
While Roth 401(k)s actually do have their own RMD requirements starting at age 72, these can easily be avoided by rolling over Roth 401(k) assets into a Roth IRA (which has no RMD requirement). Thus, by contributing to a Roth 401(k) instead of a traditional 401(k), you may be able to avoid or reduce your RMDs down the road.
You Can Contribute More in After-Tax Dollars
While the contribution limits are the same on a Traditional 401(k) and Roth 401(k), you can actually pack more dollars (on an after-tax basis) into a Roth 401(k) versus a Traditional 401(k). This is helpful if you’re maxing out all of your retirement accounts.
For example, let’s say that you have a marginal tax rate of 32% and make the maximum 401(k) contribution for 2020 of$19,500, that contribution is equivalent to making a $13,260 contribution on an after-tax basis. By making a Roth 401(k) contribution, you’d be able to cram an additional $6,240 on an after-tax basis into the account.
Reasons Why Investing in a Traditional 401(k) Might Make Sense
*Note: Most of these sections will be a little shorter, as most points are the inverse of the Roth points made above. Also note that just because it’s shorter does not mean that the Traditional 401(k) may not be the right choice for you, I just didn’t want to be redundant.
If You’re in a Higher Marginal Tax Rate Now Then You Will be in Retirement
If you’re in a very high tax bracket right now and expect to be in a lower one in retirement, then it may make sense to contribute to a Traditional 401(k) and get the tax-deduction now. Once you’re retired and in a lower tax bracket, you will be able to make annual Roth conversions at a lower marginal tax rate and still be able to reduce your RMDs down the road.
Phaseouts
Contributing to a Traditional 401(k) versus a Roth 401(k) may be the difference in getting your income under certain phaseout thresholds for various tax credits or deductions or not. A couple of the big ones to be aware of is the Student Loan Interest Tax Deduction and the Child Tax Credit. If there are certain credits or deductions with phaseout thresholds that you regularly use and your income is near these thresholds, I would do the math and make sure that the Roth 401(k) Contributions aren’t costing you a lot more in taxes than you realize.
You Already Have Some Tax Diversification
If you already have a sizeable portfolio in a taxable brokerage account and have been making Roth IRA contributions for years, you probably already have a decent amount of tax diversification and might be better off getting the current tax deduction with traditional 401(k) contributions.
You Reside in a State with High State Income Taxes
If you’re currently living in California and are paying 10% in state income taxes, but are planning to retire in Florida, where there is no state income tax, then it might make sense to invest in a Traditional 401(k) instead of a Roth 401(k).
Conclusion
When it comes to the choice of contributing to a Roth 401(k) or Traditional 401(k), several factors come into play and the best choice can vary from investor to investor. Sometimes the best choice is contributing a little to both of the options! If you’ve read through this post and have some questions that you want to discuss in more detail, or you want to talk with a professional about what option is best for you personally, feel free to schedule a free initial consultation with me.
Sign up for SFP's Monthly Newsletter to stay up to date on all of our blog posts and videos, and also to gain access to our free budgeting tool.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
