Many 401(k) and 403(b) retirement plan participants are uncertain as to the benefits of saving their contributions on a Traditional (pre-tax) or Roth (after-tax) basis.
As a reminder, although you get a current year tax deduction for pre-tax contributions, the principal and growth will be taxable in retirement. In contrast, Roth contributions are made with dollars taxed today, but the principal and growth are tax-free in retirement (assuming you are at least 59 1/2 years of age, and the Roth account has been in place for at least 5 years). Here is a Roth Comparison Chart from the IRS that explains further.
Despite these known benefits, there are also two key factors that also will ultimately determine the potential benefit of contributing to Roth:
- Will you be in a lower or higher tax bracket in retirement?
- Will tax rates increase, stay the same, or decrease in the future?
If you know for sure that tax brackets will increase in the future, the Roth option allows post-tax contributions to grow and be withdrawn with no (higher) taxes later. Simple, however, no one truly knows whether income taxes will be greater during the balance of their contribution period, or in retirement, than it is today.
One supposition we hear frequently is that “taxes always go up.” Actually, this is not the case. History shows that income taxes move both up and down over time. Admittedly, there is some logic to the assumption that, with our national debt being considerably greater than ever and increasing, tax increases seem probable. One plausible compromise approach may be utilizing both traditional contributions up to maximum employer match, and Roth for non-matched employer contributions. You can use this Traditional vs. Roth Calculator from American Funds to see how different tax rates may impact this decision.
The percentage of companies offering a Roth 401(k) option alongside a traditional plan has grown steadily in recent years, requiring a greater need for participant education. The Plan Sponsor Council of America’s 62nd Annual Survey of Profit-Sharing and 401(k) Plans, released in December 2019, showed that nearly a quarter of participants (23%) elected to contribute to a Roth in 2018 when given the opportunity, up from 19.5% in 2017 and 18.1% in 2016.1
For those that also have a traditional (pre-tax) account, remember the SECURE Act of 2019 eliminated the “Stretch IRA” that had allowed beneficiaries to gradually take distributions from inherited IRAs over the course of their lifetime. Now those who inherit a pre-tax IRA after January 1, 2020 have 10 years to withdraw the assets and pay tax on those assets, or face taxation of the money all at once (spouses and disabled beneficiaries are among the exceptions to the rule). The Roth option can mitigate this issue for individuals looking to leave some sort of inheritance to beneficiaries. Roth accounts have the same 10-year distribution limit for beneficiaries, but they have the potential benefit of reducing tax liability as Roth 401(k) distributions are not taxed like traditional 401(k) or IRA distributions.
For additional information about Roth contributions and how this could impact your retirement savings, check out our educational video Roth for Retirement: You Might Be Missing Out!
