Making the decision between a Roth or traditional 401(k) can be complicated for high-income professionals. Consider these factors to best protect your income.
What Is a Roth 401(k)?
The two types of 401(k) plans are similar in that they are both offered by employers to their employees as a retirement savings plan. The key difference between the two types of plans is that the Roth 401(k) plan allows employees to contribute after-tax dollars to their retirement savings, while the traditional 401(k) plan allows employees to contribute pre-tax dollars. With a Roth 401(k), your contributions are made with after-tax dollars, meaning you’ve already paid taxes on the money you’re contributing. This means that the money you contribute to your Roth 401(k) will not be subject to taxes, and you will not have to pay taxes on the withdrawals you make when you retire.
The Roth 401(k) has features from both the traditional 401(k) and the Roth IRA. After that, your money grows tax-deferred, and you can take it out tax-free in retirement A Roth 401(k) is beneficial because you can get the company match on your contributions if your employer offers one. Furthermore, your money grows tax-deferred and you can take it out tax-free in retirement. Roth 401(k)’s offer the advantage of tax-free withdrawals from the Roth component.
What Are the Similarities Between a Roth 401(k) and a Traditional 401(k)?
We already know the differences between a Roth 401(k) and a traditional 401(k), so now let’s talk about how they’re the same.
- Automatic contributions with every paycheck. Like we said before, these are both workplace retirement savings options. With either type of 401(k), your contributions are automatically taken out of your paycheck. Who said saving for retirement wasn’t easy?
- Free money from your employer. Both plans usually include a company match. If you work at a place that offers a match, take it. Your employer is giving you free money!
- Contribution limits. Both types of 401(k)s have the same contribution limit. In 2022, you can save up to $20,500 per year (or $27,000 if you’re over 50) in your account. The opportunity to invest that much every year is a huge perk of either type of 401(k), especially when compared to an IRA’s contribution limit of $6,000 per year.3
The Roth 401(k) includes some of the best features of a 401(k), but that’s where their similarities end.
General Guidelines for Evaluating Roth or Traditional 401(k) Contributions:
- If you’re a resident or military member, maximize Roth contributions.
- If you’re in a low-income year for any reason, such as a sabbatical, use Roth contributions.
- Use a personal and spousal Backdoor Roth IRA each year. That way, even if you choose to make all tax-deferred 401(k) contributions, you’re still getting some money into Roth accounts.
- If you can pay the tax with money in a taxable account and expect to work part-time or retire in your 50s, then consider making Roth conversions during those years before receiving Social Security or a pension to “fill up the lower brackets.”
- If you save and invest more than 20% of your gross income, lean a little more toward Roth investments. If you save and invest less, use tax-deferred accounts preferentially.
Tax Diversification Is Useful
It is possible to lower the amount of taxes you have to pay in retirement by withdrawing money from different types of accounts. This includes tax-deferred accounts (like a traditional 401(k)), accounts with preferential long-term capital gains rates, and tax-free accounts (like a Roth IRA or cash value life insurance policy). Most experts agree that on the eve of retirement, you ideally want both Roth and non-Roth accounts in your portfolio.
Don’t Forget the Backdoor Roth IRA
In 2022, a married couple can contribute $6,000 ($7,000 if over 50) each to a Roth IRA each year—usually via the back door for most high-income professionals since they make too much to contribute directly. If you’re looking for tax diversification, maxing out your 401(k) and also Backdoor Roth IRAs will give you what you need.
Marginal Tax Rate at Contribution vs. Marginal Tax Rate at Withdrawal
One of the most important things to think about when deciding between a Roth vs Traditional 401(k) is your tax rate and how it will change when you retire. It is important to remember that your contributions to the Roth IRA are made at your marginal tax rate, but you can withdraw the money at a lower rate. The taxes on 401(k) withdrawals for a married couple who took the standard deduction would be 0% for the first $25,100 withdrawn, 10% for the next $19,900, 15% for the next $61,150, and 22% for the next $91,700 in 2021.
If you contribute money and get taxed at 35%, and then withdraw money and get taxed at 35%, then it doesn’t matter which account you use. It is beneficial for doctors in their peak earning years to defer taxes whenever possible because they will have a lower marginal rate in retirement and will contribute at their marginal rate and withdraw at their effective tax rate.
But there may be some other considerations.
Political/Economic Considerations
Many people choose a Roth or traditional 401(k) based on their strong views about future political and economic possibilities. Assuming that future tax rates will be greater than present tax rates, it would be more beneficial to make Roth contributions now and pay taxes at the current, lower rate. If interest rates increase significantly, your marginal rate could be lower than your effective tax rate in the future.
Some investors are concerned that the government will break their promise not to tax Roth accounts in the future. If you’re worried that your tax bracket may decrease in the future, you may prefer to get your tax break as soon as possible with a tax-deferred contribution. Some people take their Social Security payments as soon as they are able, even though it may not be the most logical choice financially.
Other Retirement Income
If you think you’ll have a lot of income from things other than your 401(k) or IRA when you retire, you might want to consider making Roth contributions so you don’t have to pay taxes on that money later. The most common type of income is Social Security. Of retired professionals, 85% will have their Social Security income taxed. Most people will want to wait until they are 70 to start collecting social security so they won’t see this change in their earlier retirement years. Other sources of income in retirement may come from a working spouse, renting out property, investing, and pensions. The larger the sum of money you have saved in your 401(k), the greater the percentage of that money that will be taxed when you withdraw it.
Estate Planning Considerations
If you don’t intend to spend the money in your retirement accounts and would rather leave it to your heirs, Roth contributions are a great idea. The main reason is that Roth IRAs don’t have Required Minimum Distributions (RMDs) starting at age 72, unlike Roth 401(k)s. If you avoid taking RMDs from your account from age 72 until your death at age 90, the account will be larger than if you were required to take them. The heir will still receive money from the retirement account, but it will be less without the tax-deferred growth.
Once an IRA or Roth IRA is inherited, the required minimum distributions (RMDs) start based on the age of the heir. When the heir is very young, they are likely to continue to grow if they only withdraw the RMDs. An IRA that is not taxed when it is stretched has the potential to grow to an even larger sum of money that will not be taxed (since it can grow without being taxed for an additional 10 years after death before withdrawals are made). Your beneficiaries will naturally want you to pay the taxes rather than them. If your heirs don’t make much money, they may have a lower tax rate than you. However, the heirs will have to pay more in taxes if they inherit the house.
If you wish to donate your retirement account to charity, a tax-deferred account would be more beneficial as it would mean neither you or the charity would have to pay taxes on the money. If you use money from your IRA to make a donation, you will not be able to deduct the amount from your taxes.
If you are above the estate tax exemption limits, both Roth money and tax-deferred money will be subject to estate taxes. However, Roth money is actually more after-income-tax money.
Why We Recommend the Roth 401(k)
If you’re investing a fixed amount every month, you’re doing it right! The most important part of wealth building is consistent saving every month, regardless of how the market is performing.
We’ve discussed the benefits of these two types of accounts. However, just to be clear, the Roth IRA is superior for the following reasons.
Tax Benefit
Although it may be appealing to reduce your taxable income in the present in order receive a larger paycheck, it is important to consider the long term effects this may have. You may as well do it in a way that could earn you more money. You are working hard to save for retirement, so you might as well do it in a way that could earn you more money. Why not do everything you can to make your money last longer during retirement?
This is something else to consider: tax brackets and percentages may change in the future, especially if retirement is still far off. Do you want to take that risk?
Emotional Toll
It is difficult to keep emotions separate from investing. Wouldn’t it be terrible if, after working so hard to save up $1 million for retirement, taxes reduced that amount to less than $800,000? You would rather pay taxes now in order to save money later. You will miss $100,000 in retirement much more than you will miss $100 in a paycheck now.
If you can start investing 15% of every paycheck into a Roth 401(k) early on, you won’t miss the money that you’re paying in taxes. When you retire, you will be happy that you don’t have to give the government part of your savings.
Who Is Eligible for a Roth 401(k)?
If your employer offers it, you’re eligible. This means that anyone can contribute to a Roth 401(k), regardless of how much money they make. That’s a fantastic feature of the Roth option! You can contribute to a Roth 401(k) no matter how much money you earn.
If you do not have access to a Roth option at work, you can still take advantage of the Roth benefits by working with an investment professional to open a Roth IRA, as long as you meet the income requirements.
How Much Should I Invest in a Roth 401(k)?
You should be investing 15% of your income into retirement savings only if you’re debt-free and have a fully funded emergency fund. Let’s say you make $60,000 a year. This means that you would invest $750 in your Roth 401(k) every month. See? Investing for the future is easier than you thought!
If your workplace offers a Roth 401(k) with good mutual fund options, you can invest your entire 15% contribution there. Boom, you’re done! You can invest more than just your 401(k) up to the match, you can also max out a Roth IRA on your own.
Can I Contribute to Both a Roth 401(k) and a Traditional 401(k)?
Yes. You may be able to contribute to both a Roth 401(k) and a traditional 401(k) in certain situations. Mostly, it depends on the options available to you. If you have a Roth 401(k) with investment options that are expected to grow, you don’t need to invest in a traditional 401(k). The Roth 401(k) offers many benefits, including tax-free growth and tax-free withdrawals in retirement, that make it a great investment. We recommend investing your entire 15% in a Roth 401(k).
We feel that the best option is Match, followed by Roth, and lastly traditional. Let’s break it down.
- Match: We will always take free money. Who wouldn’t? So, if your employer offers a match, invest enough to get it all. It’s a 100% return on investment!
- Roth: Second, do all the Roth you can through employer-sponsored or individual accounts. At retirement age, the majority of your Roth 401(k) or IRA balance will be growth.
- Traditional: If you don’t have a Roth 401(k), invest up to the match in your traditional 401(k). Then max out a Roth IRA. If you still haven’t hit 15% of your income with those options, then go back to your traditional 401(k) and invest the rest.
Kurt has gone from the financial lows of the ’08 financial crisis to personal financial success. He is a professional real estate investor, media buyer, faithful Red Sox Fan.
One of his passions is financial education and the pursuit of financial freedom.
You can learn more about Kurt here, or get a hold of him on Facebook or Twitter.
