Should I make Roth or traditional 401(k) contributions?
This is a question Fiduciary Financial Partners get asked almost every week, so we decided to write a blog on the topic to help you improve your retirement outlook.
As much as we'd like to be able to give the same answer to everybody – it's not that simple. Every person's situation is going to determine which approach is best for them. However, we are going to try to boil these decisions down into one single variable.
For context, let's look at some of the features and benefits of the Roth 401(k). The big selling point is that we get tax-free growth on our accounts forever. That means we don't pay taxes on our account growth along the way, nor do we pay taxes on withdrawals from our Roth 401(k) in retirement. Additionally, we are not required to take minimum distributions starting at age 72, as we are with the traditional 401(k).
To take advantage of that tax-free growth, we have to pay taxes before we make contributions. In other words, we make our contributions with after-tax dollars.
We can contribute much more to a Roth 401(k) than to a Roth IRA. In 2022, a person under 50 can put $20,500 into a Roth 401(k), but only $6,000 into a Roth IRA. So people who know they want tax-free withdrawals in retirement can accumulate a lot more money by utilizing the Roth feature in their company's 401(k) plan.
The last feature we are going to touch on is that Roth 401(k)'s are not subject to the income limitations applied to Roth IRA's, which don't allow investors to contribute to them if their income is too high. For the Roth IRA, contributions are phased out based on your modified adjusted gross income (MAGI) and filing status. For single filers, the limit begins at $125,000 and is completely phased out at or above $140,000. For married filing jointly, the phase-out starts at $198,000 and is completely phased out at $208,000. However, you can make Roth 401(k) contributions no matter how much you earn.
Now let's briefly look at the traditional 401(k): In a traditional account, every dollar I defer into the plan reduces my taxable income by a dollar. We say our contributions are made with pre-tax dollars. The growth on the account is tax-deferred. Year over year, when you earn a return on your account, you keep 100% of that return in your account to compound. Then, the withdrawals from the traditional plan are taxed as ordinary income in retirement.
In both Roth and Traditional 401(k)'s the contributions limits are the same, and the investment choices are the same. The difference big difference is how/when those accounts are taxed. So that is the variable we are going to focus on when we make the decision about which one is better for an individual participant.
In short, you want to pay your taxes when your tax rate is the lowest. In the graphic above, we see that if our tax rate in retirement is going to be lower than it is now during our working years, if we're in that group at the top of the chart, we should go with the traditional option.
On the other side, if we're going to be paying taxes at a higher rate in retirement than we are now, then we should go with the Roth. We forego the tax deduction today in favor of tax-free withdraws later, when our taxes are higher.
But how do we know when our taxes are going to be higher?
Our tax code is based on a graduated system where we pay a higher percentage of our income in taxes the more money we earn. Our income, combined with our filing status determines which tax bracket(s) affects us. Since we can't predict future tax rates, the factor we should focus on is our income. If our income is higher now than it's going to be in retirement, we should make traditional contributions. If our income is going to be higher in retirement, we should make Roth contributions.
What are some things that might help us determine when our income is going to be higher?
One of the biggest is age. If a person is young, if they're in the early stages of their career, then they probably have a lot of upside potential to their income. Their income is likely lower now than it will be in the future. Additionally, young people just have more time for their money to compound. This makes the tax-free growth of a Roth more attractive, as more compounding periods should lead to higher tax-free account balances.
Compare that to a person in their 50's who is the peak earning years of their career. They have never made as much as they are earning now, and they are unlikely to have more income in retirement than they have right now. In that case, the traditional option is the way to go.
The last thing we want to say about Roth vs. Traditional 401(k) is that with all the choices participants have to make, it's easy to fall into the trap of paralysis by analysis. Set a goal to save at least 10% of your income into your retirement account and you are much more likely to enjoy a comfortable retirement. If you aren't saving enough, it's not going to matter which one you pick.
If you have any more questions, we are just a phone call away. To schedule a call with one of our fiduciary financial advisors – click here. Thanks for reading.