My son introduced a board game, the Settlers of Catan, or Catan, for short, to my wife and me several months ago. The objective of Catan is simple: be the first one to collect 10 victory points.
Victory points are obtained by building settlements and cities, each one worth one and two points, respectively. You can also earn victory points by holding various types of cards, including special victory point development cards.
As my wife and I have learned from gracious defeat at the hands of my son on multiple occasions, strategic play is essential to winning Catan. This begins with the placement of two settlements and two roads to start the game.
Like Catan, achieving success in the 401(k) world starts with focusing on the objective. Beginning in 1981 when the IRS issued rules allowing employees to fund 401(k) plans, the primary goal was to maximize tax-deductible contributions subject to individual financial constraints. Many plans offered, and continue to offer, an incentive to do this with employers matching employee contributions up to a specified level.
The fact that 100% of tax-deductible contributions plus earnings would be taxable when you took withdrawals from the plan wasn’t the most important consideration in the early to mid-80s when the top federal tax rate was 50% and a $7,000 contribution cost you only $3,500 after factoring in tax savings. Although few did, you could invest the income tax savings from contributions to pay tax on withdrawals from the plan, if that were important to you.
The Rules of the 401(k) Plan Game Have Changed
The rules of the 401(k)-plan game changed when Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that created the Roth 401(k). This gave 401(k) plan participants, including self-employed individuals with solo 401(k) plans, the option of making nondeductible contributions to a Roth 401(k) account in exchange for nontaxable withdrawals.
In addition to choosing the percentage of salary to contribute to your 401(k) plan among different investment choices, you needed to decide the allocation between traditional versus Roth assuming the latter was offered. There are short- and long-term consequences associated with each choice.
Roth 401(k)s Changed the Retirement Planning Conversation
The Roth IRA, which was established by the Taxpayer Relief Act of 1997 and was the precedent for the Roth 401(k), didn’t move the dial on the way that retirement planning was practiced. This was due to two factors, both of which still exist today: (a) income test for making contributions and (b) low contribution limits. Whereas traditional and Roth IRA contribution limits increased from $2,000 in 1998 to $6,000 ($7,000 if age 50+) in 2020, traditional and Roth employee 401(k) plan contribution limits increased from $10,000 to $19,500 ($26,000 if age 50+) during the same period.
With its higher contribution limits, the Roth 401(k) expanded the retirement planning conversation from one that was strictly about maximizing tax savings to optimizing lifetime after-tax distributions. The focus of 401(k) planning and holistic retirement planning shifted from accumulation, or retirement asset planning, to decumulation, or retirement income planning. This occurred against a backdrop of sustained federal tax rates of 40% or less beginning in 1993, with a top rate of 37% beginning in 2018.
Traditional 401(k) Income Tax Liability Likely to Exceed Tax Savings
The income tax liability attributable to taking withdrawals from a traditional 401(k) is likely to exceed the tax savings from deductible contributions in many situations. The primary reason for this is the fact that total after-tax contributions to a 401(k) plan will generally be far less than total after-tax withdrawals due to the following factors:
- Annual contribution amounts and associated tax savings are often modest for the first several years of participation for younger employees due to lower salary amounts and other financial priorities.
- Tax-deferred growth on employee and employer contributions will generally be responsible for a large portion of the long-term value of a 401(k) plan.
- Tax-deferred growth will continue long after contributions cease in most cases.
- Required minimum and other distributions from a traditional 401(k) often increase one’s income tax rate and taxable portion of Social Security benefits.
- Surviving spouses pay higher taxes on taxable 401(k) plan withdrawals.
- The longevity of a traditional 401(k) plan and taxable withdrawals is increased to the extent that a plan is bequeathed to survivors, which it often is.
- Nonspouse survivors inheriting a traditional 401(k) plan may be subject to higher income tax rates under the 2020 SECURE Act requirement to take withdrawals of 100% of inherited retirement plan accounts by the end of the tenth year after the plan participant’s death.
Given the likelihood that cumulative after-tax withdrawals from a traditional 401(k) will often be much greater than cumulative after-tax contributions, larger after-tax lifetime withdrawals are possible with a Roth versus traditional 401(k) plan. Current low-income tax rates that are scheduled to sunset after 2025 potentially tilt the scale further in favor of the Roth option for the next several years.
Winning at the 401(k) Game
Winning at the 401(k) game, similar to Catan, requires strategic play focused on the objective of maximizing lifetime after-tax distributions. Like Catan where there are different strategies for collecting 10 victory points that can change during a game, each individual needs to evaluate and periodically reevaluate the traditional versus Roth 401(k) choice as it pertains to her situation. Given the fact that 401(k) plans are often one’s largest financial asset, there’s a lot at stake.