Pre-tax contributions vs. Roth 401(k) contributions – A Retirement Strategy
By John E. Shields, CPA, CFE
In a defined contribution 401(k) or 403(b) plan, a participant typically has the option to have deferrals withheld from payroll on a pre-tax basis. As noted in earlier articles, one of the upcoming trends is a 401(k) plan offering participants after-tax Roth contributions inside of the retirement plan. If your retirement plan allows for Roth 401(k) deferrals, how do you decide which option is best?
Both options result in taxes, however the difference is when the tax is paid (now with the Roth option versus later when the money is distributed with pre-tax) and how much it will cost in tax dollars and future benefits. Saving in a Roth 401(k) allows for company contributions to still be made to your account. and Loan provisions are typically still the same.
For pre-tax 401(k) contributions:
- Taxes are deferred until the funds are withdrawn by means other than a qualifying rollover.
- The portion of the contribution, that would be taxable under the Roth option, enters the plan and begins earning dollars sooner.
- All earnings are taxable at the date of distribution.
- If no withdrawals are made, they become mandatory at age 70 ½ as required minimum distributions. These distributions are included as ordinary income, which could reduce benefits from Social Security and Medicaid.
For Roth 401(k) contributions:
- Taxes are withheld and paid on contributions as normal income at the participant’s current income tax rate.
- Withdrawals and related earnings are tax-free assuming:
- the funds are not distributed within the 5-year participation period, and
- the funds are not distributed prematurely or through a hardship withdrawal.
- Required minimum distributions are required, like with the traditional 401(k), but they are not taxable. Therefore, they do not reduce benefits from Social Security and Medicaid.
- Roth 401(k) funds may be transferred to a Roth IRA, and the required minimum distribution requirements are no longer applicable.
How to Decide
Deciding on which way to go can be tough. Trying to determine if your tax rates will be more or less in retirement is even more tough. There are so many variables to compare that it can make your head spin. Here is a scenario to help you make a decision.
Person A and Person B (both making $50,000 per year) defer 7% into a retirement plan offered by their employer. Person A chooses the traditional 401(k) and Person B chooses the Roth 401(k) option from the plan. The same amount of money goes in to the account. Let’s assume that both accounts achieve a 7% annual return for the next 20 years. However, Person A, who contributed to the traditional 401(k), has a tax liability, and Person B has an account with more money to spend in retirement because the taxes were already paid.
Upon retirement, Person B will not have a tax liability when receiving the Roth distribution. However, when the 7% contribution is made to the plan, Person B will receive a smaller paycheck because the contribution is taxable. Person A does not pay tax on the amount of the contribution to the traditional 401(k) which results in more take home pay. Therefore, a Roth strategy is most beneficial for a person who is currently in a lower tax bracket but anticipates moving to a higher tax bracket upon retirement.
This scenario is simple, and there are many different variables that can affect the outcomes of the example above. However, it does provide a quick look into the great option of the Roth 401(k). It is not just for young people that are just starting a career. In addition, with the Tax Cuts and Jobs Act (TCJA) that passed in late 2017, this would be a great time to contact your tax advisors to discuss your options. Tax rates have changed, so the traditional thinking of a 401(k) needs to be revisited.