close

Roth 401k, Pre-Tax 401k, Or Both?

401k plan participants often wonder whether they should contribute their hard-earned money to a Roth 401k or a pre-tax 401k account. Depending on their age and tax bracket, the answer may be both!

Many 401k plan participants have the option of making pre-tax 401k contributions and Roth 401k after-tax contributions. Roth 401k contributions (along with all accumulated earnings) can be withdrawn tax-free if distributed due to a qualifying event from a Roth 401k account that has been in existence for at least five years.

Pre-tax 401k contributions (and the associated earnings) are taxable when removed from a 401k plan. I have found that 401k participants are generally unclear on how they should choose between these two options. Following are some thoughts.

Roth 401k: A simple rule of thumb
If you believe tax rates will be higher in the future, it makes sense to make all or most of your contributions to a Roth 401k account now rather than to a pre-tax 401k account. The logic is that it is better to have your contributions taxed at a lower rate now as opposed to a higher rate in the future (since pre-tax 401k contributions and earnings aren’t taxed until withdrawn).

Most economic experts would agree that both state and federal tax rates are probably at historic lows. Regardless of whether you believe that is true, it is hard to imagine that tax rates will be lower in 10 years than they are now.

The answer
Both. Recent research indicates that because of the uncertainty surrounding future tax rates, most 401k participants would be wise to contribute to both regular pre-tax 401k and Roth 401k after-tax accounts.

Some participants tell me that they are leery of making any Roth 401k contributions because they don’t believe that the government will continue to allow for tax-free withdrawals at retirement. Michael Kitces recently wrote a great blog piece about why he thinks the Roth promise will stick. And he is very convincing.

He believes that one of the biggest reasons the federal government will keep its Roth promise is because unwinding it and taxing balances does not produce enough tax revenue. All revenue-raising proposals are now scored by Congress on their ability to produce revenue. Taxing Roth balances just doesn’t score highly enough. The second major reason that Congress won’t go back on its promise, according to Kitces, is that breaking it would hurt older folks and retirees the most. And older folks vote!
If you accept that state and federal tax rates could vary wildly over the next 30 to 40 years, that the government will keep its Roth promise, and that the best strategy is to contribute to both accounts, then the final question to answer is how much participants should contribute to each account.

What participants should do
Age has a significant effect upon the percentage split between each account, as does income level. Consider these recommendations:

Participants in their 20’s are probably always better off making nearly 100% of their 401k contributions to Roth 401k accounts. Possibly for their entire careers. Given that they have 40 or more years to contribute, the large balances they could accumulate and withdraw tax-free at retirement make a 100% Roth 401k contribution strategy very attractive.
Participants in their 30’s and 40’s are likely to benefit most from a mixed contribution strategy. In other words, it may be best for them to make some of their contributions to a Roth 401k account and some to a pre-tax 401k account. They should consider a 60%/40% Roth/pre-tax split in their 30’s and closer to a 50%/50% split in their 40’s.
Participants in their 50’s and 60’s may find that making Roth 401k contributions provides a way to diversify their tax planning strategies. Some participants may benefit from making only Roth 401k contributions because they can afford to pay taxes now while they are working. Since participants in this age group are closer to retirement, consideration of a Roth 401k contribution strategy should be harmonized with a participants financial plan for retirement. In nearly all cases either tax planning or retirement planning considerations will probably end up driving the contribution strategy for these age groups.

A Roth 401k account can be established with as little as a $1 in Roth 401k contributions. All 401k plan participants should start a Roth 401k account as soon as possible to get their Roth five-year clock started. Once the five-year period is met, any future Roth contributions are immediately eligible for tax-free treatment. There is not a separate five-year clock for every Roth 401k contribution made.

No Comments

Leave a reply

Story Page
%d bloggers like this: