Everyone knows that retirement planning is important, but it can be hard to generate enthusiasm about getting started. And once you get beyond the basics, it gets pretty complicated pretty fast. To help you and your family navigate these difficult decisions, we recently sat down with our very own Jamie McCreary, Certified Financial Planner™ professional, and asked her for some help in weighing Roth vs. traditional 401(k) contributions.
Jamie divides this big issue into several dimensions — including time horizon, what you plan to use the money for, and tax considerations now and in the future (since tax law is continually changing) — and for each offers some advice to consider, perhaps in conjunction with your investment and tax professionals.
Arnerich Massena: Maybe you can start by explaining the difference between traditional 401(k) contributions and Roth contributions.
Jamie: 401(k) plans were initially started to provide people with tax advantages if they saved for retirement. Traditional 401(k) contributions are pre-tax and lower your current taxable income. Savings grow tax-deferred and you pay ordinary income tax on withdrawals. Later, a Roth option came along, which some plans allow, in which your contributions are made after taxes, but any qualified withdrawals are tax-free. Both options, traditional and Roth, have tax advantages; the difference is when you reap those advantages.
Arnerich Massena: Which type of 401(k) contribution is better to make: traditional pre-tax, or Roth after-tax?
Jamie: Unfortunately, there’s no one-size-fits-all answer, but my first piece of advice is to simply start contributing in any form. The more years before retirement, the more time there is for your investment to grow, whether it’s in a traditional or Roth 401(k).
The next easy piece of advice is this: if your employer matches any of your retirement contributions, you should definitely take advantage of that. Employer match assets are pre-tax and will be taxed as ordinary income upon withdrawal.
Then we can start looking at which type of contribution will fit your situation better, which depends on your age and the time horizon before you will need to access your money.
Arnerich Massena: How should your age and time horizon affect your decision?
Jamie: It all depends on when you want your tax break. If you are nearing retirement and just need to save as much as possible, traditional, pre-tax contributions may allow you to save more. But if you are younger, in a low tax bracket, and with a longer time horizon, you have enough time for your investments to grow and offset a smaller up-front contribution. Tax-free distributions later on can be a significant advantage, so if you have that time, a Roth may be more beneficial. Risk tolerance also plays a role: more aggressive investors may want to consider a Roth 401(k), as the income generated by your investments is tax-free.
Keep in mind that you can divide your deferrals to make both traditional and Roth contributions to your 401(k) plan.
Arnerich Massena: You mentioned considering when you want to take the tax break. How does your tax bracket fit into the picture?
Jamie: You have at least three tax buckets that you can use: your Roth 401(k), your traditional 401(k), and your taxable accounts. We hear a lot about diversification across asset classes. It is also important to diversify your tax structure. Different investment vehicles have different tax implications. Tax law is continually changing; since you can’t be exactly sure of what tax environment you will find yourself in upon retirement, tax diversification can also be a powerful strategy.
For example, if Social Security and mandatory traditional 401(k) Required Minimum Distributions meet your regular expenses, then your Roth can be a great way to pay for something like a big trip or a new roof without incurring higher income taxes.
Arnerich Massena: I know that you also ask people what they plan to do with the money they are investing in their retirement accounts. Can you explain why you ask that?
Jamie: It may seem like a surprising question as many people assume that of course it’s all for retirement. But estate planning and charitable giving desires can affect your decision.
For instance, if you plan to continue saving your money after you retire to pass along to the next generation, you may want to consider a Roth 401(k). A traditional account has required minimum distributions (RMDs), which require you to withdraw a certain amount annually once you reach age 70 ½. A Roth 401(k) account, however, can be rolled into a Roth IRA, which does not have RMDs and can be passed on income tax-free at death.
If you are planning to make charitable contributions in retirement, you can roll over your 401(k) into an IRA. The Consolidated Appropriations Act of 2016 finally made permanent qualified charitable distributions (QCDs) from individual retirement accounts. With a traditional IRA, you get an income tax deduction when you put money in and once you reach age 70 ½, you can donate up to $100,000 to a charity without paying taxes. That’s a real tax advantage for someone who doesn’t need the RMD amount to live on.
Arnerich Massena: We’ve covered a lot of ground. What would you like to leave us with?
Jamie: I know that there is a lot of complexity and uncertainty, but I would urge you not to let that paralyze you, which is definitely not a good retirement strategy! Start saving now, take full advantage if there is a match offered by your employer, and consider what’s best for your situation. Remember that you can make contributions to both your Roth 401(k) and traditional 401(k). You can also always seek advice from your tax and investment professionals.
Note: This article is provided for educational purposes only and is based on current tax law, which is subject to change. It includes information drawn from third-party sources believed to be reliable but not independently verified or guaranteed by Arnerich Massena. We do not represent that it is accurate or complete, and it should not be relied on as such. This material does not constitute investment advice or contain investment recommendations, which would need to take into account a client’s particular investment objectives, financial circumstances, and needs. Investments and strategies discussed herein may not be suitable for all readers, and you should consult with an investment, legal, tax, and/or accounting professional before acting upon any information or analysis contained herein. To the extent that this material concerns tax matters, it is not intended to be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Investors should seek independent advice from a tax professional based on individual circumstances.