More employers now are offering Roth 401(k) options in their employer-sponsored retirement plans. The Roth retirement plan offers some attractive benefits and this option merits some considerations for retirement savers.
There are some key differences between a Roth 401(k) and a typical 401(k), but the primary difference boils down to, do I pay my taxes now, or do I pay my taxes later?
With a traditional 401(k), contributions made to the plan are treated as pre-tax, which reduces current adjusted gross income. Some refer to this pre-tax treatment as “tax deductible.” Regardless of the term used, contributions into traditional 401(k)s are not taxed, which can provide an immediate benefit of roughly 10% to 25%, depending on income and tax rates.
The trade-off to this immediate tax benefit is that when funds are later withdrawn from the plan for retirement spending needs, the amount withdrawn is taxed as income.
With a Roth 401(k), on the other hand, contributions made to the plan are made on an after-tax basis, meaning the money is taxed before it goes into the plan with no immediate tax benefit to the saver.
The primary incentive to forego the immediate tax benefit of the typical 401(k) is that when funds are withdrawn for retirement from a Roth 401(k) they are not taxed as income, often referred to as tax-free withdrawals.
Both types of plans allow for tax-deferred growth during the accumulation period before retirement, and it's not hard to envision the benefits of long-term compound growth with the tax free withdrawals of the Roth 401(k). The combination can be a very powerful wealth accumulation tool.
The Roth IRA was actually put into the tax code 22 years ago, and the Roth 401(k) 13 years ago, and I feel most people by this time have a decent basic understanding of the tax benefits, but I still get the question as to whether a Roth plan is the “the better deal.”
Well, we have now had a good look at the new tax laws signed into law in 2017. Despite the political rhetoric, with the expansion of the standard deduction and the enhancement of the child tax credit, the tax law is looking very advantageous to middle income taxpayers. Using an IRS tax calculator it looks like a married couple with two children pay no federal income tax on the first $61,000 of income, for a single parent of two this number is $47,000.
Obviously, for taxpayers who won’t pay material income taxes anyway, the Roth 401(k) is the “better deal.” A five minute call to the tax preparer or a Google search for an online tax calculator can help determine how much income tax can be expected to be paid. The amount of a “tax return” is a poor gauge.
Under the new tax code, in my opinion the Roth option looks like an attractive option for middle income savers, but higher income families might want to take a look as well. While the immediate tax benefit of the traditional plan may hold more allure, the Roth 401(k) may be the only way higher income folks can accumulate tax free retirement funds as the ability to contribute to a Roth IRA is completely “phased out,” or not allowed, for single taxpayers earning $137,000 and couples earning $203,000. This phase-out does not apply to the Roth 401(k).
This discussion is beyond the limits of this column, but with more employers offering the Roth 401(k)s, and the changes in the new tax rules the Roth option merits another look for 2019.