When To Use a ROTH 401K
KEY TAKEAWAYS
If you are concerned about income tax rates increasing when you retire, a ROTH 401K would be a better option since your withdrawals will not be subject to taxes.
A ROTH 401K may be a better choice today, if you have significant pre-tax retirement savings already and anticipate high required minimum distributions bumping you into a higher tax bracket in the future.
ROTH accounts make for a much better inheritance transfer tool since your beneficiaries will not be subject to taxes when they access inherited funds.
ROTH 401Ks could be a great tool for retirement for highly compensated young professionals with little possibility of their income tax rate ever decreasing.
Roughly 75% of employers that Fidelity serves as an administrator offer a ROTH option in their 401K plans. If you were amongst the lucky 75%, when you enrolled into your 401K and were customizing contributions, you may have noticed that you had a choice between a Traditional or a ROTH 401K. Most people select the “Traditional 401K” option, and only 13.6% opt to contribute to a ROTH account. It could very well be that majority of plan participants do not take the time to research which choice would serve them better and go with the safe sounding “Traditional” option. So, when does it make cents (HA!) to choose one over the other? The answer depends on your financial priorities now versus the future, let’s take a look.
Future Tax Rates: If you believe that tax rates will be higher when you retire, you would most likely be best served using a ROTH 401K. Math is straightforward in this case; if you are in a lower tax bracket today, why not pay a lower tax now and enjoy tax free withdrawals in your retirement? If you were to contribute to a Traditional 401K in this case, then your tax deduction today would be lower than your tax liability when you must draw on your retirement savings.
Another scenario where future tax rates will be a determining factor is if your tax bracket will not change at all. If you are very successful and in the highest tax bracket today, with no prospects of ever being in a lower tax bracket – then one might as well pay the tax today and save for retirement in an account from which withdrawals are tax-free throughout your retirement. In this case a ROTH 401K would give you more tax planning flexibility and would not contribute to your already high tax bill.
Required Minimum Distributions (RMDs): Once you turn 72 years young, the almighty IRS requires you to start withdrawing from your retirement savings accounts; 401Ks, traditional IRAs and the like. If you did the right thing and saved as much as you could into a retirement account throughout your life – but have not saved any “after-tax” funds – each and every dollar you withdraw from a retirement account will be taxable and could distort retirement income and tax picture by large annual RMDs. While there may not be such a thing as saving too much, it is possible to put too much into a “Pre-Tax” account like your Traditional 401K.
This is where a ROTH 401K saves the day – even though IRS requires to take RMDs from Traditional and ROTH 401k accounts, there is no RMD requirement for ROTH IRAs. Which means that you can do a rollover and move your savings from a ROTH 401K to a ROTH IRA – and avoid distributions, especially if you do not need the income. This ties in nicely with the next point we will review.
Legacy considerations: If you pass away and leave your heirs Traditional and ROTH IRAs – they are likely going to be happier receiving ROTH portion of inheritance. Recently passed laws require that inherited IRAs must be completely distributed over the next 10 years by your heirs. Withdrawals from a Traditional 401K or IRA may increase your heirs tax bill for the next decade. For example, if an inherited IRA balance is $500,000 and one has 10 years do deplete the account, that’s an additional $50,000 of taxable income each year, and that is without any growth!
While the original owner of a ROTH IRA does not have to take Required Minimum Distributions at all, heirs must distribute the entire account over 10 years. The difference is that distributions from ROTH IRA will not have any impact on your heirs’ taxes since distributions are tax-free.
Having both types of accounts can be helpful when planning on who to leave which dollars. A simple example we can use is if one has two offspring – one extremely successful and one that is not as lucky. Since the successful child is in a high tax bracket already, it is more tax efficient to transfer a ROTH IRA to him/her and since the second child is in a low tax bracket – it may be more efficient to leave your Traditional IRA to this child.
It is important to note that if you open a ROTH IRA account specifically for the purpose of receiving ROTH 401K Rollover funds – there is a “5-Year Rule” you must abide by. While any funds you rollover are available for withdrawal tax and penalty free right away, any growth in the account is subject to a withdrawal penalty that goes away after 5 years.
Are there any circumstances under which a ROTH 401K is NOT a good fit?
So far, we investigated circumstances under which a ROTH 401k might serve you well, lets look at the flip side of the coin and explore when a ROTH account may not be as advantageous.
Charitable Considerations: If you are planning on leaving a portion of your assets to a cause that’s close to your heart, a ROTH IRA may not be the best source of funds to do so. Since charities are non-profit organizations – they are exempt from paying income taxes. Leaving a ROTH 401K or IRA to a charity will not provide any additional benefit to the cause. So, if you have a Traditional 401k or IRA and a ROTH 401k or IRA – a much more tax efficient approach would be to leave ROTH assets to your heirs and Traditional 401K/IRA to the cause of your choice. This way, neither charity nor your heirs will have to pay any taxes. Nothing to see here IRS agent, please move on.
Future Tax Rates: If you are currently in the highest tax bracket and at the peak of your career, but you are planning on being in a lower income tax bracket before your retirement – you may want to contribute to a Traditional 401K account now and once your income drops – switch to contributing to a ROTH 401K.
Another scenario where this may work is if you are in the final stretch before your retirement, your income is high, you are in a high tax bracket and you are diligently saving to beef up your nest egg before you turn in your parking pass. If your income drops off substantially after you retire, you may come out ahead if you contributed into a Traditional 401K while you work and then after your income drops – start converting Pre-Tax dollars from your Traditional 401K into a ROTH IRA. That way your tax deduction will be higher while you worked than the tax liability from your ROTH IRA Conversions after retirement.
Employer’s Match: It is important to note that some employers will not match your contributions to a ROTH 401K and only match your contributions to the Traditional 401K. So, the first step in determining if/how to save into a ROTH 401K is to check with your HR or Plan Administrator what rules apply to you. If your employer matches only contributions to the Traditional 401K, you then should contribute to the Traditional 401k up to the employer’s match limit and any contributions above the match can go into the ROTH 401K, if permitted by your employer plan.
Conclusion: While standalone factoids and “clean” academic cases may make a ROTH 401K seem like a clear-cut winner – in reality, there is no winner in this race. Simply because no one knows what our future holds. We don’t know if taxes will be higher or lower when we retire, we also can’t be 100% certain if our income in retirement will be higher or lower. With a 30–40-year planning horizon, there is enough uncertainty to make the photo-finish image blurry. So instead of picking one over the other, it may be better to instead tax-diversify your portfolio; elect to contribute into both a ROTH and Traditional 401k plans. That way you will walk into retirement with flexibility to manage your taxes, legacy and annual RMDs that will not make your accountant gasp.
Sources:
www.barrons.com/articles/roth-401k-vs-traditional-good-bad-deal-51635541029
https://www.kiplinger.com/article/investing/t001-c000-s002-invest-in-a-roth-401k-if-you-can.html
https://www.nerdwallet.com/article/investing/roth-401k
https://www.bankrate.com/retirement/traditional-401k-vs-roth-401k/
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