In some company 401k plans, you have the option of investing your EE (employee) contributions as pre-tax “Traditional” contributions (the way you have always done it) OR post-tax “Roth” contributions (the newer option). Let’s clear up a few possible misconceptions:
Roth is not a “change” to your 401k plan. Adding the Roth 401k option is an enhancement to your plan. Think of it as having an additional option on top of the existing plan. Both types of contributions (pre-tax and post-tax) are great ways to save for retirement. Your task is to determine which one may be the better fit for your personal financial situation. If you do decide to elect to invest your EE contributions going forward in the Roth 401k, it will not impact your existing balance up to that point. It will simply make your future EE contributions the Roth (post-tax) variety. Any future ER (employer) contributions will stay and continue to be of the Traditional pre-tax variety, regardless of what you choose for your EE contributions.
You are fortunate to have this Roth 401k option. The majority of plans do not currently have this option available to employees. In the future, will they? If we had a crystal ball, the answer likely would be yes. However, many companies are slow to add them for a variety of reasons. For now, if you have this option, that’s a good thing.
A Roth 401k is not the same as a Roth IRA. Although similar in terms of how taxation works, a Traditional IRA is not the same as a 401k and a Roth IRA is not the same as a Roth 401k. IRA stands for INDIVIDUAL (you) Retirement Account. A 401k plan is designed for the company and sponsored by the company, so it is an EMPLOYER plan, albeit by law it must be built to benefit and protect the interests of the employees of the plan. We are talking 401k plans here, not IRAs.
A Roth 401k is not an “investment” rather it serves as a tax-advantaged vehicle for retirement. The investment is what you actually own inside of it, typically a mix of mutual funds offered by your employer. Your investment funds determine your performance and level of risk/volatility. The status of the account type, Roth/Traditional, determines the taxation particulars of your funds.
Traditional vs. Roth could be re-phrased as “Do I want the tax break now (as I earn the income) or later (as I take distributions in retirement)? In the case of the Traditional, you don’t pay income taxes as you earn it. Your employer routes the money out of your paycheck and invests it directly into your 401k plan, exempting it from being taxable income in the current year. It goes into the plan and grows for years on a tax-deferred basis (i.e. no taxes on dividends, interest, and capital gains). When you take distributions in retirement, you are paying yourself your own paycheck. You pay income taxes then on what you take as a distribution. For the Roth, you pay income taxes today as you earn it. Your employer still routes the money out of your paycheck and invests it directly into your plan. However, taxes are withheld on your income. It will go into the plan and grow for years on a tax free basis AND will be tax free when you take distributions in retirement.
Doesn’t this just seem overly complicated? Well, it is and it isn’t. The challenge is that there isn’t one “right answer” for making this decision. What you are looking at is really a set of what ifs, a set of pros/cons, mixed in with a degree of uncertainty regarding the future. In the end, you need to educate yourself and understand the pros, cons, what ifs, and uncertainties. Understanding these 5 factors will aid your ability to make this decision:
1) How do the income tax brackets generally work?
This is not specific tax advice, it is general in nature and meant for informational purposes only. “Married Filing Jointly” is a common type of tax filing status; let’s look at that tax table for 2017:
– From $0 -$18,650 of taxable income, 10% federal income tax.
– From $18,651 – $75,900 of taxable income, 15% of federal income tax.
– From $75,901 – $153,100 of taxable income, 25% of federal income tax.
– From $153,101 – $233,350 of taxable income, 28% of federal income tax.
– From $233,351 – $416,700 of taxable income, 33% of federal income tax.
– From $416,701 – $470,700 of taxable income, 35% of federal income tax.
– Above $470,700, 39.6% of federal income tax.
The first part is to know roughly where you fall within these brackets (if not married filing jointly, an internet search will yield your applicable tax bracket structure). If you select the pre-tax Traditional option, your federal tax rate % is an estimate of income tax you save today on contributions (i.e. a couple filing jointly with taxable income of $100,000 would receive an ~25% savings on their plan contributions……100$ into the plan would cost $75 of income). With the Roth option, you give up the current tax savings in hopes that your tax savings is > 25% in the future.
2) What is my earnings potential going forward?
This part is more subjective than objective. This is where the numbers/math people struggle. They typically want it black and white. We don’t have that luxury here. However, the more you have a pulse of where your earnings/taxable income is headed going forward, the less complex this analysis becomes. You need to size up the bracket you just saw or your applicable bracket.
It is likely that you generally fit one of three basic scenarios:
1) Where you land in the brackets is low relative to where you expect to land in future years (income likely to rise significantly in future years).
2) Where you land in the brackets is about where you expect to land in future years (income likely to rise year-by-year at about the rate of inflation; 2-3% on average)
3) Where you land in the current brackets is high relative to where you expect to land in future years (income is remaining flat or expected to be declining in future years)
At this point, you need to broadly understand the brackets themselves, where you generally fit today, and where you expect to be in future years relative to where you are today.
3) What does the math say?
The math says the two options are a wash (i.e. no benefit gained by selecting one over the other). For this “wash” to happen in all practical terms (real life), two things must exist. One, our congress would have to resist the urges they may have and keep the bracket income rate %’s the same adjusting the income dollar amounts over time only to account for inflation. Two, your position within the brackets would remain constant. It is likely these two factors will not remain the same throughout your working career. The odds are this “wash” is theory only.
4) What in the world is “tax diversification?”
“Investment diversification” makes sense to most as an understood and accepted concept of personal finance. Don’t put all your eggs in one basket (See: Enron). Tax diversification is much lesser known and understood, yet important. By having a variety of account types (pre-tax and post-tax) you increase your retirement options. All things being equal, having both pre-tax and post-tax “buckets” of money at your disposal in retirement gives you more flexibility.
It’s important to remember a few key issues that impact taxes. One, contributions made to your plan by the ER are always Traditional (pre-tax) even if you select your EE contributions to be 100% Roth. Two, the Roth decision is not an all or nothing proposition. You could select as your EE contribution 4% Roth, 4% Traditional to arrive at a total of 8% (or any combination thereof). If you have a large % of your retirement dollars already on the Traditional side and/or are adding high Traditional contributions, it may be wise to start diversifying your income tax situation.
5) Can my decision impact my estate and/or my kids’ inheritance?
This is not specific legal advice, it is general in nature and meant for informational purposes only. It can. The fact is most of you envision your retirement accounts serving the obvious purpose of funding your retirement. However, in the event that your money or a portion of it ultimately winds up being inherited by your children, another individual, or an entity it is more desirable for that inheritor to receive after-tax assets over pre-tax assets as those Roth accounts maintain tax preferential treatment. Additionally, post-tax Roth accounts do not have RMDs (Required Minimum Distributions) associated with them, while pre-tax do.
The Roth feature is a positive and beneficial option in your 401k plan. Most companies still do not offer this feature. A Roth 401k is not the same as a Roth IRA. A Roth 401k is not an “investment” but rather a tax-advantaged vehicle, what you own inside of it is your investment. Roth says “I want the tax break later, in retirement;” while Traditional says “I want the tax break today.” The most important element in your decision is to generally understand where you are in the current US Income Tax Brackets and your own judgment of if you are heading up, down, or remaining relatively constant in your future years of income. In general, the younger you are and the more likely your income will rise significantly in future years would lead you in the direction of making Roth contributions. If that is not you, then the other features of tax diversification and estate benefits may be enough to tip the scales. Ultimately, your decision should take into account your entire financial picture and be customized to the specifics of your life.