Employer-based retirement plans provide a powerful mechanism for W-2 employees to reduce their tax liability and save for retirement. But far too often people do not take advantage of this important benefit. The reasons for not participating or under-participating are varied, but many lose out because they imagine using a 401 (k) to be a difficult and complex process. And, based on this assessment, decide it is not worth it and not for them. Others believe there is no benefit to long-term investment. These perceptions is understandable, but are demonstrably incorrect and harmful. Utilizing a 401 (k) is generally straightforward and impactful. Moreover, it generally only requires four decisions:
- Decision #1: How Much to Save?
- Decision #2: Which Contribution Option is Right?
- Decision #3: How to Invest?
- Decision #4: Who Will Be the Beneficiary?
This article is the first in a series and focuses on Decision #2.
The Big Difference
The vast majority of 401(k) plans offer two contribution options: (i) traditional contributions and (ii) Roth contributions. The critical difference between the two options is when income taxes are paid.
Traditional contributions are made on a pre-tax basis. Thus, taxable income is immediately reduced by the contribution and no taxes are paid on the amount of the contribution at the time the income is received. Instead, income taxes are paid when the funds are distributed to the account holder in retirement.
Roth contributions are made on an after-tax basis. Thus, taxable income is not immediately reduced by the Roth contribution. Instead, taxes are paid on total income, and, after taxes are paid, the Roth contribution is made. Therefore, when distributions are taken in retirement, there is no tax due on qualified withdrawals. (A withdrawal is qualified if the account owner has held the account for more than five years and is more than 59 ½ years old. Unqualified withdrawals may be subject to an IRS penalty.)
Importantly, there is no scenario or 401(k) vehicle that allows for taxes to be fully avoided. The big difference boils down to paying income taxes now (Roth contributions) or paying income taxes later (traditional contributions).
Another Important Difference
Aside from when income taxes are paid, there is another important difference between traditional contributions and Roth contributions. It concerns required minimum distributions (RMDs).
Unless an account holder is still working, RMDs must be taken from a Traditional 401(k) starting when the account holder reaches 72 years old.1 Thus, at that time, distributions must be taken from the account according to a formula prescribed by the IRS. And, when funds are distributed from a Traditional 401(k), they are subject to income taxation at the ordinary, applicable income taxation rates.
The same RMD rule applies to a Roth 401(k), except that qualified distributions from a Roth 401(k) are not subject to income taxation. However, once distributed, gains, dividends, and other earnings from the distributed amount will be subject to taxation. Fortunately, there is a workaround available: the same RMD rules do not apply to a Roth IRA while the account holder is alive. Thus, by rolling a Roth 401(k) into a Roth IRA, an account holder may be able to avoid taking RMDs – and thus paying taxes on future earnings of the distributed amount – during their lifetime.
What is the Impact of Each Option on Current Income?
A traditional contribution will have less impact on current income. Taxable income is reduced via a traditional contribution. Thus, there is an immediate tax savings to current income. Taxable income is not immediately reduced with a Roth contribution. Thus, there is no immediate tax savings and there is a greater impact on current income. Generally speaking, this difference is more pronounced when current income is higher and less pronounced when current income is lower.
Indeed, at certain current incomes the immediate difference is almost negligible – and the greater economic benefit will likely appear at the time distributions are taken:
Who Might Benefit From Roth Contributions?
There are several general categories of people that might benefit from Roth Contributions.
- Young investors. Young investors generally have a longer time horizon for tax-free growth. They may also be in lower tax brackets now and thus could benefit from paying taxes now instead of later. (This same logic applies to anyone, not just young savers, in a lower tax bracket. I.e., pay now, when you know you are in a lower tax bracket.)
- Investors who want to leave tax-free money to beneficiaries. Investors who want to leave heirs tax free inheritance may be able to do so via Roth contributions.
- Investors looking to diversify their tax treatments in retirement. Roth contributions may provide investors different tax-related options in retirement. In other words, if an investor has half of their retirement funds in a traditional, pre-tax account, and half of their retirement funds in a Roth account, then that investor may be able to pull from each account in a way that allows for optimized tax treatment. This may particularly apply to individuals that are not eligible to save in a personal Roth IRA due to income restrictions.
Another, very general shortcut that might help determine which sort of contribution might be best is to look at taxation history. If someone generally receives a refund after filing annual tax returns, then that person may want to consider Roth contributions. If someone generally must pay additional taxes with their annual tax returns, then traditional contributions may make the most sense.
Note that this is not an all-or-nothing decision. 401(k) contributions can be split between traditional contributions and Roth contributions in whatever way makes sense for the investor.
In general, early, significant, and sustained participation in a 401(k) plan is a powerful way to obtain tax benefits and save for retirement. It can make a real difference in quality of life in retirement and this benefit should be maximized as much as possible. With that in mind, deciding what type of contributions to make is certainly important – but it should not be a bottleneck that slows participation. Of course, consulting with a trusted and knowledgeable financial professional is always a good idea and can help with precisely this sort of decision.
1] The rule concerning when RMDs recently changed with the passing of the SECURE Act 2.0. While the RMD requirement age remains at 72 for individuals born in 1950 or earlier, as of January 2023the age moves from 72 to 73, and in 2033, the age moves to 75.
Author: John Marquet
Jon Marquet is the Retirement Plan Consultant at Trust Point Inc. He is a licensed attorney in Minnesota, Iowa, New York, and New Jersey. He works with business owners to identify and address their needs in connection with employer-based retirement plans. He also works in concert with plan sponsors, plan participants, and others in Trust Point Inc.’s Retirement Plan Services group to initiate, administer, and regularly review client employer-based retirement plans. He has presented and written on numerous and various topics throughout his career.