When you become a participant in a 401(k) plan that includes a Roth option, you face an interesting dilemma. In addition to deciding what percentage of your salary you would like to contribute to your plan, you need to let your plan administrator know how your contributions should be allocated between the plan’s traditional and Roth accounts.
A lifetime decision
The allocation of traditional vs. Roth 401(k) contributions is a decision that shouldn’t be taken lightly. It’s a lifetime decision that will impact the life of your retirement funds for you, your spouse, and potentially your children and other beneficiaries.
Most people don’t think about, let alone analyze, how their retirement-plan contributions will transform into after-tax income streams when they retire, especially if they’re in their 20s and 30s. Undue emphasis is often placed on front-end income-tax deductions. It’s relatively easy to calculate the amount of income-tax savings you will realize by contributing $10,000 to a traditional 401(k) plan. It’s much more difficult figuring out how much after-tax income you will receive from your $10,000 contribution 30 years from now.
The importance of making retirement-contribution decisions within the context of a retirement-income plan is paramount for those who have 401(k) plans that allow them to make contributions to a Roth account. The potential dollars at stake justify this approach.
Limited only by compensation, employees who are less than 50 may make pretax contributions of up to $18,000 or $24,000 if 50 or older, with potential employer-matching contributions. Total annual contributions, including after-tax contributions, can be as much as $53,000.
Roth contributions win on the back end
Roth contributions win hands-down when taking withdrawals provided that a Roth 401(k) participant rolls his/her Roth 401(k) assets to a Roth IRA before Jan. 1 of the year in which he/she turns 70½. Traditional and Roth 401(k) plans and traditional IRAs are subject to the IRS’s required-minimum-distribution (RMD) rules beginning at age 70½. The RMD rules for Roth IRAs don’t kick in, however, until a beneficiary inherits a Roth IRA.
Traditional 401(k)s and traditional IRAs (see “The 401(k) Unlevel Playing Field” for a discussion of differences) grow tax deferred. Distributions are fully taxable unless they originate from after-tax contributions. The increase in taxable income can trigger larger taxable Social Security benefits, higher marginal and effective tax rates, and increased Medicare premiums.
Roth 401(k)s and Roth IRAs, on the other hand, are tax exempt. Assuming that you’re at least 59½ and your initial contributions were made at least five years ago, withdrawals are nontaxable.
Greater after-tax retirement withdrawals possible with Roth 401(k)
Greater lifetime withdrawals are possible with a Roth vs. traditional 401(k). This is likely since the income-tax liability attributable to withdrawals from a traditional 401(k) will often be much greater than the income-tax savings from contributions. Lifetime withdrawals from a Roth 401(k) plan will also be larger to the extent that the income-tax savings from contributions to a traditional 401(k) aren’t reinvested.
To illustrate this, let’s use assumptions that would seem to favor making contributions to a traditional vs. Roth 401(k).
First, we’ll maximize annual deductible contributions and income-tax savings attributable to traditional 401(k) plan contributions. Ignoring potential increases in contribution limits due to inflation, let’s assume maximum annual pretax contributions of $18,000 from age 25 through 49, $24,000 beginning at age 50, and a top marginal tax bracket of 39.6% each year. This translates to annual income-tax savings of $7,128 through age 49 and $9,504 beginning at age 50.
To increase the potential attractiveness of making contributions to the traditional vs. Roth 401(k), let’s also use a much lower income-tax bracket of 25% at retirement. This is reasonable given projected sizable annual withdrawals from the traditional 401(k) plan.
Other assumptions used in this example are as follows:
- Retirement at age 66.
- A 401(k) participant or spouse who is the same age survives to age 90.
- Beneficiary is 61 when he/she inherits and is required to take distributions from the account and lives to at least age 85.
- Required minimum distributions are taken from the traditional 401(k) plan account beginning at age 70½.
- The Roth 401(k) is rolled over to a Roth IRA before Jan. 1 of the year in which the account owner turns 70½.
- Annual withdrawals of $100,000 are taken from the Roth IRA account beginning at age 70½ until the death of the original account owner.
- Beneficiary takes required minimum distributions from the traditional 401(k) and the Roth IRA account.
- Beneficiary’s marginal tax rate is 25%.
- One hundred percent of income-tax savings from making contributions to the traditional 401(k) plan account is reinvested in an interest-bearing account earning 4%.
- Traditional and Roth 401(k) and Roth IRA accounts grow at 4% per year.
Using the foregoing assumptions, the inherited traditional and Roth 401(k) accounts will be depleted at the beneficiary’s age 85 as a result of the higher RMD factors that are applied to beneficiary vs. original account-owner investment-account values to determine annual withdrawal amounts.
Excluding after-tax earnings from potential reinvestment of 401(k) plan withdrawals and without taking into consideration the present value of income-tax savings and income-tax liability, the following is a summary of the calculation of projected total withdrawals net of projected income-tax liability from the traditional vs. Roth 401(k):
|Variables||Traditional 401(k)||Roth 401(k)||Difference|
|Income Tax Savings from Contributions||330,000||-330,000|
|Net Earnings on Income Tax Savings Account||514,000||-514,000|
|Less: Total Income Tax Liability||1,318,000||-1,318,000|
|Total Withdrawals Net of Income Tax Liability||4,798,000||5,733,000||935,000|
In this example, the Roth 401(k) projected total withdrawals of $5.733 million exceed the traditional 401(k) projected after-tax withdrawals of $4.798 million by $935,000, or 19.5%. This is primarily due to the fact that the projected total income tax liability of $1.318 million attributable to traditional withdrawals is four times greater than the projected income-tax savings of $330,000 attributable to traditional contributions.
To the extent that the projected income-tax savings from contributions isn’t reinvested in an income-tax savings account, which is usually the case, the projected total withdrawals from the traditional plan would be $4.284 million, or $1.449 million less than the projected total withdrawals of $5.733 million from the Roth plan.
Maximize your Roth 401(k)
The allocation of traditional vs. Roth 401(k) contributions is crucial to determining the amount of after-tax withdrawals from your 401(k) and IRA during your lifetime, your spouse, and potentially your children and other beneficiaries. While immediate income-tax savings from traditional 401(k) plan contributions is tempting, the long-term benefits may pale in comparison to the difference in after-tax withdrawals that can be obtained by making Roth vs. traditional 401(k) contributions.
Don’t be afraid to forego income-tax deductions by making contributions to your Roth 401(k) account if your retirement income-plan projections show that after-tax withdrawals during your family’s lifetime will be greater.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.