As more employers are making the Roth 401(k) available to employees, many investors wonder if they should contribute to the after-tax option and how to best allocate their contributions.
Traditional 401(k) plans aren’t the only type of retirement plan that can have a Roth component; 403(b) and governmental 457(b) plans can also have a separate Roth account. For simplicity, we’ll only use the traditional 401(k) plan in this comparison, although the general guidance is largely consistent across 403(b) and 457(b) plan types also.
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Traditional 401(k) versus a Roth 401(k). In a traditional 401(k), employees typically make pre-tax contributions. While this lowers your taxable income for the year, you will owe income tax on your contributions and investment growth when you withdraw the money in retirement. If you take out any funds before age 59½, you will also owe a 10 percent penalty unless the reason falls under an exemption. Your income tax rate in the year of withdrawal will determine how much you’ll pay in tax.
In a Roth 401(k), employees contribute after-tax dollars to the designated Roth account within the 401(k) plan. You will not have any tax advantages in the current year, but for investors who wait at least five years from Jan. 1 of the tax year in which the initial contribution was made and certain other conditions are met for a qualified distribution, there will be no future tax due, not even on the earnings component. Similar to a traditional 401(k), early withdrawals may be subject to income tax and a 10 percent penalty.
Investors can contribute to both a traditional 401(k) and a Roth at the same time, but the maximum annual contribution is aggregated and cannot exceed $18,000 in 2016 for those under age 50. Employers are able to match Roth contributions, but their additions will be added to the pre-tax account.
How a Roth 401(k) differs from a Roth IRA. A Roth IRA has income limitations that restrict many individuals from contributing. In 2016, to make the maximum contribution married couples filing jointly cannot have a modified adjusted gross income over $194,000 and single filers cannot exceed $132,000. The maximum regular contribution in 2016 is $5,500 for those under age 50. There are no income limitations on Roth IRA conversions, however, which are permitted once a year.
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Perhaps the most impactful difference between the two is required minimum distributions. Similar to a traditional 401(k), a Roth 401(k) will require minimum distributions to begin by age 70½. Roth IRAs do not have any withdrawal requirements during the original account owner’s lifetime. Why is it beneficial to avoid RMDs? Retirees with a large concentration of tax-deferred assets may find themselves in a much higher tax bracket than expected after calculating their required minimum distributions, depending on their asset level.
Is it always better to use a Roth? The answer to this is simply, no; using a Roth 401(k) (or IRA) is not always the best choice for an investor. Like most investments, the Roth analysis will be largely speculative — based on your current situation and tax law, as well as your projections for the future. Here are some instances where it may make sense to further investigate a Roth 401(k):
— You are in a relatively low marginal income tax bracket currently and expect that to increase in retirement.
— You have sufficient excess free cash flow to make meaningful and ongoing after-tax contributions.
— Your retirement savings or expected income (Social Security, pension, etc.) are heavily weighted towards tax-deferred assets.
A Roth 401(k) can be a great option for investors to diversify their retirement savings, but it isn’t always a winning strategy. Tax-deferred accounts often end with higher values compared to Roth accounts as the investor can afford to contribute more. Over time, the additional amount invested will experience compounded growth, and in some cases, produce a higher after-tax return than a Roth account. Work with your financial advisor to determine which solution is best for you.
Roth 401(k) rollover to Roth IRA. A central difference between the Roth 401(k) and IRA is the absence of required minimum distributions in the Roth IRA. For Roth 401(k) plan participants, there is still a way to access this feature. When you leave your employer or retire, you will have the option to roll the Roth 401(k) into a Roth IRA. The assets will need to be transferred after separation from service and before Jan. 1 on the year the participant turns age 70½ to avoid RMDs.
With a Roth 401(k) to Roth IRA rollover, it is important to note that without an existing Roth IRA, the rollover will restart the clock on the five-year period for qualified distributions. For those with a Roth IRA already in place, the rollover will assume the same holding period.
Allocations between Roth and traditional 401(k) accounts. How much an investor should allocate between pre-tax and after-tax retirement savings will depend on the person. Cash flow and the impact on the current tax situation are the most common reasons participants are reluctant to shift exclusively to Roth contributions, even for a few years.
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While your allocation will ultimately be a personal decision, be sure to have a strategy in place before making any decisions. Unless you feel you can make contributions that will be proportionally substantial to your tax-deferred savings over time, the benefits of a Roth account in retirement may not be worthwhile, especially when considering the quantifiable tax tradeoffs today.
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Should You Use a Roth 401(k) or a Traditional 401(k)? originally appeared on usnews.com
