When it comes to planning for retirement do you think the traditional 401(k) or the relatively newer Roth 401(k) is better? The answer depends on your current salary, your long-term financial goals, and how you think taxes will change in the future.
Contribution Levels: Both the traditional and Roth 401(k) allow participants to contribute $19,500 for 2020. They both offer a $6,500 catch-up provision for participants age 50 or older, increasing contributions to $26,000. Both accounts are eligible for an employer match, which when combined with an employee's contribution, cannot exceed $57,000. If the employee is age 50 or older the amount is $63,500 due to the catch-up provision. The employer match is one of the best aspects of either 401(k) account because it allows participants to double their money risk free. If you contribute $10,000 and your employer matches this amount you have doubled your savings risk free!
Tax-Benefits Now: A key factor to consider when choosing between these two accounts is your current marginal tax rate. If you have a high paying job your next dollar earned may be taxed at 32% to 37%. If you contribute to a traditional 401(k) you can avoid these taxes by sheltering this income. But you will pay taxes on these contributions, plus any employer match and any gains, when you withdraw this money at age 59.5. However, once you are retired and no longer working full-time you are likely to be in a lower marginal tax bracket. Perhaps a 15% bracket instead of 32%.
Avoiding AMT and NIIT: A second benefit of a traditional 401(k) is the ability to lowering your taxable income and avoid certain tax penalties. This includes the Alternative Minimum Tax, which can reduce your allowable tax deductions if you itemize, which in turn will increase the amount of income tax you pay. The Balance reports that the AMT hits 60% of taxpayers making between $200,000 and $500,000. Although, if you take the standard deduction when you file the AMT is less of a concern.
A second tax penalty you can avoid by using a traditional 401(k) is the Net Investment Income Tax (NIIT). The NIIT is imposed by the Internal Revenue Service at a rate of 3.8% on certain net investment income. The NIIT applies to individuals with income above $125,000 and married filers earning $250,000 or more. If you use a traditional 401(k) to reduce you income below these levels the NIIT would not apply.
Tax Benefits Later: Contributions to a Roth 401(k) are made after tax, so your contributions will not reduce your income taxes for the year. However, your contributions and any gains, which could be significant if your contributions have had many years to grow, are not taxed when you withdraw them at age 59.5. Please note, if your employer's contributions to your Roth 401(k) are made with pre-tax dollars, that portion of your withdrawal will be subject to tax.
In the long run a Roth 401(k) could be far more advantageous if withdrawals remain tax free. Tax regulations are not set in stone and the government periodically revises these regulations. This could have an impact on future Roth 401(k) distributions. The U.S. national deficit exceeded $25 trillion in 2020, this debt also continues to rise. Eventually this debt needs to be repaid, and that means marginal tax rates are likely to rise. It also means more sources of income may become subject to tax. For example, in January 2015 the Obama administration proposed ending the tax benefits of 529 college savings plans, the measure did not pass, but is was seriously considered. This would have been a major setback for many families or individuals saving for college.
Have Both: Fortunately if you are not sure which 401(k) is better you can have a mix of both. You can split your annual contributions between a traditional 401(k) and a Roth 401(k) benefiting from some tax deductions now and hopefully some tax free withdrawals in the future. A tax efficient way to use this strategy is to maximize your Roth 401(k) earlier in your career when your income is lower and more likely to be in the 12% or 22% marginal tax bracket. At these lower marginal tax rates it is more advantageous to invest in a Roth 401(k). As your income rises mid-career you can add more contributions to a traditional 401(k) to keep your income below the next highest marginal tax bracket or low enough to avoid some of the tax penalties mentioned above.
RMDs: One last factor to consider with both accounts is Required Minimum Distributions or RMDs; which are mandatory withdrawals that begin at age 72. (Note in 2020 RMDs were suspended for the year in response to the COVID-19 recession.) Both a traditional 401(k) and a Roth 401(k) are subject to RMDs. As you grow older each year a larger percentage of your portfolio is subject to RMDs. Currently, RMDs are more of a concerns for a traditional 401(k) as these withdrawals will increase your taxable income, which can lead to more of your monthly Social Security Retirement Benefits also being subject to tax. You can reduce these taxes by blending in withdrawals from a Roth 401(k) or a Roth IRA. See the example below:
Roth 401(k) withdrawal: $8,000
Roth IRA withdrawal $1,000
Traditional 401(k) withdrawal: $6,000 (taxed)
Total income: $15,000 (but only $6,000 is subject to tax)
Retiring early and building wealth requires creative strategies that are also tax efficient. Asset diversification is important, but so is asset allocation. Having a blend of tax deferred and tax free accounts will help reduce your long-term tax obligations. If you are interested in more lessons like this and creating a mindset that is focused on financial Independence see the book Become Loaded for Life!
