Which is better for you? Contributing to a pre-tax traditional 401(k) account or an after-tax Roth 401(k) account? As with most financial issues involving tax laws, the answer depends on many variables. To determine which type of 401(k) might work best for your situation, let’s first consider the key differences between these two types of accounts:
- The Roth 401(k), which has been available since 2006, is a relatively new investment option. Contributions to Roth 401(k) accounts are after tax. In other words, you contribute to your retirement account with money from your paycheck after it has already been taxed. Withdrawals are tax-free – as long as you meet certain rules.
- In contrast, contributions to a traditional 401(k) reduce your taxable income for the contribution year; however, when you withdraw money in retirement, the withdrawal counts as taxable income. Additionally, employer-matching contributions are pre-tax (i.e., you aren’t taxed on your investment earnings while your savings grow; however, withdrawals during retirement count as taxable income).
Required minimum distributions (RMDs) from both traditional 401(k)s and IRAs commence at age 70½. In addition, the maximum contribution to a retirement plan, such as a 401(k), is $18,500 for 2018 – regardless of whether the contribution was made to a traditional 401(k), a Roth 401(k), or a combination of the two. Participants in 401(k) plans who are 50-years-old and older in 2018 can contribute an additional $6,000 for a total of $24,500.
When deciding between the two types of 401(k) accounts, one of the most important factors to consider is how your current marginal income tax rate will compare with your future marginal income-tax rate after you retire. In other words, will you be in a higher or lower tax bracket in retirement relative to where you are now?
One common assumption, which may not be correct, is that you’ll be in a lower tax bracket because you’ll no longer be working; thus, you should contribute to your traditional 401(k). That’s risky though because no one knows what tax rates will be in 20 years. And considering tax rates are near historical lows with a large federal deficit, it’s likely that future rates may be higher.
Consider the example of a 70-year-old single taxpayer whose $100,000 taxable income the year prior to retirement puts her in the 24% tax bracket. She has a traditional pre-tax 401(k) balance of $2 million with no Roth 401(k) savings and she receives $30,000 annually from Social Security benefits:
- In this case, our retiree must take an RMD of $75,471 from her 401(k), which will be taxed at ordinary income rates. This income, in turn, causes 85% of her Social Security benefit to be taxable, which keeps her in the same tax bracket she was in while working.
- If that balance was in a Roth 401k, she wouldn’t need to take any distributions and her taxable income would remain at $30,000.
- Her RMD not only bumps her to a higher tax bracket, it increases her cost for Medicare Bart B. (Under the Affordable Care Act, Medicare participants with certain income must pay a surcharge. See the income-related surcharges to Medicare Part B.)
To learn more:
- Calculate your RMD.
- See which types of income are taxable and will (or may) be an added cost.
As you can see, when deciding how to allocate your 401(k) savings, it’s essential to consider your total tax burden in retirement. In the example above, there’s also a high probability that this taxpayer will be in a higher rate in retirement than pre-retirement; therefore, utilizing Roth 401(k) options would have been prudent.
General advice for most people out there is to do everything in their power to save taxes currently. However, each person’s situation is different, including current composition of tax-free, tax-deferred, and after-tax assets. And, of course, income.
There’s no one-size-fits-all answer, so consider your personal situation and don’t use general rules when making these decisions. Your Redwood advisor can help you with a specific recommendation.
