A common question I get asked as an advisor is whether to sign up for a traditional 401(k) or a Roth 401(k) plan through an employer. A traditional 401(k) is funded with pre-tax money, so you pay taxes when you retire, while a Roth 401(k) is funded with after-tax money so during retirement the withdrawals are tax-free. Both types of retirement savings plans are governed by the same contribution limits, so you can contribute the same max amount (plus an additional $6,500 catch-up contribution if you are over age 50) to one or the other account. The only difference is when you pay taxes.
If you don’t expect any material change in your income tax rate between your working years and retirement, it generally won’t make a difference whether you choose a traditional 401(k) or a Roth 401(k). However, if you do expect some variation in your income tax rate, it makes sense to dig a bit deeper before making a final decision.
A major goal when making retirement contributions is to minimize taxes when your tax rate is high. But this is not always an easy thing to know because you must anticipate how your federal, state, and local income taxes could change over time. If you are working in a state with high income taxes, like California or New York, and you plan on retiring in a state with low income taxes, like Florida or Texas, using a traditional 401(k) would be preferred since the expected savings in state income tax today are likely to exceed the expected increase in federal income taxes in the future.
Though you cannot predict future tax rates, you can estimate how much income you will need in retirement and where you plan to live during your retirement years. Having these two pieces of information can help to clarify whether you should contribute to a traditional 401(k) or a Roth 401(k).
I generally recommend that clients contribute to a traditional 401(k) because a Roth doesn’t have the same conversion option. Especially if you’re a parent with kids at home, you may want to take the tax deduction now to help you save on taxes and increase your cash flow.
With a traditional 401(k), you have more control over when and where you pay your taxes since you may be living in a different state when you retire. If you experience a period of lower income, it may present a great opportunity to convert a traditional 401(k) into a Roth individual retirement account (IRA) at a lower tax rate.
For example, individuals who stop working prior to their full retirement age (around 66 or 67) and don’t start taking Social Security immediately may see a significant drop in their tax rate. This can be a tax-efficient time to convert. The same holds true for changing your retirement address to avoid cities and states that impose larger income taxes. Therefore, it doesn’t make sense to contribute to a Roth 401(k) while living in New York City unless you know that you are going to retire in an area with a similarly high tax rate. For many of us, the added flexibility associated with a traditional 401(k) is what, in my opinion, makes it the employer-sponsored retirement plan of choice.
If you are a high saver, then a Roth 401(k) may make more sense for you. Maxing out a Roth 401(k) places more total dollars into a tax-deferred account than if you were to max out a traditional 401(k).
Let’s say you max out your 401(k) in 2022 by contributing the full allowed amount of $20,500 ($27,000 if you are over age 50). While the $20,500 contribution into a Roth 401(k) is with post-tax dollars, the traditional 401(k) is with pre-tax dollars. In this hypothetical scenario, after 30 years earning 5% annually, you now have $1,360,000 in your retirement account. Unfortunately, with a traditional 401(k), you must pay income taxes on your retirement funds. Assuming you pay 30% in taxes, a traditional 401(k) will leave you with $953,000, to spend in retirement versus the $1,360,000 tax-free in a Roth. For a traditional 401(k) to have a balance of $1,360,000 after taxes, the amount of the pre-tax contribution would need to be $29,242 (over the maximum yearly contribution cap of $20,500 for 2022).
This example demonstrates that a Roth 401(k) is probably the better choice for high savers, as you get more total tax-deferred benefits. Secondly, high savers may find that they are unable to take advantage of some of the options of using a traditional 401(k). For example, you can convert a traditional 401(k) with a high account balance to a Roth IRA. But this conversion may put you into a higher tax bracket than you initially planned for, which means you’re losing out on the tax advantages.
Another reason to consider a Roth 401(k) is if you expect to be in a higher tax bracket in retirement. For example, let’s assume that you expect your federal effective tax rate to increase from 24% while working, to 32% during retirement. This implies that the Roth 401(k) would be the better option, as you would pay a lower tax rate now (24%) than you would expect to pay in retirement (32%). Also, if you expect to leave assets to heirs and you want your heirs to inherit assets tax-free, a Roth may be the better choice.
For most of us who follow the normal salary curve, it makes sense to use a Roth 401(k) early in your career and then contribute to a traditional 401(k) later as your earnings increase. This strategy helps you avoid the highest tax brackets during your highest earning years and provides flexibility when making retirement withdrawals. It might be the best solution, especially if you work in a high tax state and plan to retire in a low tax state.
During the early years in professional life/career when people are starting families, cash flow is the biggest concern. Salaries are typically lower, daycare costs a fortune, first homes bring large mortgages, and retirement and college savings are competing forces. People are inclined to contribute to a tax-deductible 401(k) to save money in these years so they have more disposable income for life’s needs. Contributing to a traditional 401(k) makes sense for cash flow purposes.
So, for young professionals and families, the early years are when they have the most deductions (high home mortgage interest, child credits, daycare credits) and income is typically lower. That’s why we typically recommend contributing to a Roth 401(k) to get even longer tax-deferred growth and pay less tax as they progress through their career. It’s desirable to have different income buckets you can utilize when you’re in retirement to maximize your tax benefits. The bigger point is to make sure you are saving, period. Any opportunity to save, you should take advantage of building up your retirement funds. In fact, if you contribute to a Roth 401(k) you will automatically have a traditional 401(k) component if your employer offers any contribution matching.
Everyone’s financial situation is different, and you must account for differences in state tax treatment, current income, and retirement expectations that influence what is the best choice. Speak to your advisor about how these strategies, if implemented now, can make a significant difference in the balance of your retirement account at the end of your career.
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