Traditional 401(k) or Roth 401(k)?

Peter A. ScilovatiFebruary 13, 2020

Retirement Planning

We often get the question from our clients: “My company offers a Roth option within my 401k plan, should I put a portion of the money I am deferring in my 401(k) into the Roth option as well as my traditional pre-tax option?”

We’ve often advised our clients to consider the question from a holistic financial planning perspective. One of the things to consider, among many, is a client’s long-term legacy intentions. Another consideration is the personal decision to forego the upfront tax savings from the pre-tax option in favor of tax-free growth and tax-free withdrawals under the Roth option. Given the trend of marginal income tax brackets, the flexibility of Roth accounts, and overall retirement withdrawal strategies, a strong case can be made for at least partial Roth 401(k) contributions.

Let’s first look at some of the facts related to a Roth option within a 401k plan. The Roth option within a 401(k) plan was introduced in 2006 and was designed to combine features from the traditional 401(k) and the Roth IRA. Simply stated, the Roth 401(k) option takes the tax treatment of a Roth IRA and applies it to your workplace plan. Both a traditional pre-tax 401(k) and a Roth 401(k) option could include a company match.  In order to fill the Roth 401(k) bucket or sleeve, contributions come out of your paycheck after taxes with no reduction of your taxable wages.  In order to fill the pre-tax or traditional 401(k) bucket or sleeve, contributions are made pre-tax, which reduces your taxable wages. In the Roth 401(k) bucket there are no taxes on qualified distributions in retirement. In the pre-tax or traditional 401(k) bucket distributions in retirement are taxed as ordinary income.  The term “qualified distributions” means that withdrawals of contributions and earnings In the Roth 401(k) bucket are not taxed if the distribution is considered qualified by the IRS. “Qualified” means the account has been held for five years or more and the distribution is due to disability, death, or after attaining age 59½. Unlike a Roth IRA, you cannot withdraw contributions from the Roth 401(k) bucket at any time.  In the pre-tax or traditional 401(k) bucket distributions may incur a 10% tax penalty in addition to regular income taxes if taken before age 59½, unless you meet one of the IRS exceptions.

Keep in mind, the 401(k) contribution limits apply to both your Roth and traditional 401k options combined. In 2020, an employee can contribute up to $19,500 per year, not including employer matching dollars. Workers 50 or older get to contribute an extra $6,500, for a total of $26,000.  Let’s also keep in mind, contributions to Roth IRAs are limited based on Modified Adjusted Gross Income whereas the Roth 401(k) option does not have a similar limit. If you earn too much to be eligible for the Roth IRA, the Roth 401(k) is a chance to get access to the Roth’s tax-free investment growth and tax-free withdrawals. Currently, the phaseout for Roth IRA contribution eligibility begins at $196,000 Modified Adjusted Gross Income for a married couple filing jointly and $124,000 for a single.

Again, the choice comes down to paying taxes now or in retirement. You may want to get the tax benefit of a pre-tax contribution when you think your marginal tax rates are going to be the highest. If you believe your marginal tax rate will be significantly higher in retirement than it is now, participating in a Roth option may make sense, because qualified withdrawals will be tax-free.  If you believe your marginal tax rate will be significantly lower in retirement than it is now, the traditional option may be more appropriate, because you will pay a lower tax on your withdrawals.

If you have no idea what your likely marginal tax rate will be in retirement splitting your retirement money between both types of accounts may be the preferred strategy.  The strategy can give you taxable and tax-free withdrawal options when it comes time to live off your retirement savings. We call this strategy, using both types of contributions, tax diversification. It gives you the ability to manage your taxable income so that you stay in certain tax brackets in retirement, which can be very advantageous for retirees. In a nutshell, the source of your withdrawals and the sequence in which you tap those sources can be very important for managing your taxes in retirement.

Let’s talk about sequencing of withdrawals. How and when you choose to withdraw from various accounts: 401(k)s or traditional IRAs, Roth accounts, and taxable accounts.  But from which accounts (and when) should you be taking that money?  Traditionally, many advisors and planners have suggested withdrawing first from taxable accounts, then tax deferred (Ex. pre-tax 401k bucket and traditional IRAs) accounts, and finally Roth accounts where withdrawals are tax free. The goal being to allow tax-deferred and tax-free assets to grow longer as a client ages.  For most people with multiple retirement saving accounts and relatively even retirement income year over year, a better approach might be proportional withdrawals. Once a target amount is determined, an investor would withdraw from every account based on that account’s percentage of their overall savings. The effect is a more stable tax bill over retirement, and potentially lower lifetime taxes and higher lifetime after-tax income.  By spreading out taxable income more evenly over retirement, you may also be able to potentially reduce the taxes you pay on Social Security benefits and the additional income-based premiums you pay on Medicare.

However, if you anticipate having a relatively large amount of long-term capital gains from your investments in retirement, there may be a more beneficial strategy. First use up your taxable accounts, then take the remaining withdrawals proportionally.  The purpose of this strategy is to take advantage of zero or low long-term capital gains rates, if still available. Current tax rates on long-term capital gains (applied to assets that are held over 1 year) are 0%, 15% or 20% depending on taxable income and filing status. Assuming a Married filing jointly status, total taxable income would need to exceed $80,000 before any capital gains taxes would be owed.  If taxable income is between $80,000 and $496,600, again using a Married filing jointly status, the long-term capital gains rate is 15%. If Adjusted Gross Income is over $250,000 the additional 3.8% Net Investment Income Tax applies to investment income. Remember, the amount of ordinary income impacts long-term capital gain tax rates. Once the taxable account is exhausted, the proportional approach can then be applied.

As always, we are here to help you navigate the decisions you make during your working and savings years and through your retirement years.



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