With more and more employers offering a Roth option as part of their 401(k) plan, is this a good idea for you?
The answer, of course, is: It depends. Let’s look at some factors to consider.
No Income Limitations
Unlike with a Roth IRA, there are no income limitations for contributing to a Roth 401(k). With a Roth IRA, married couples earning over $194,000 are ineligible to contribute. There is a phaseout on contributions that starts at an income level of $184,000.
For single filers, the phaseout starts at $117,000, and no contributions are allowed once your income reaches $132,000.
With a Roth 401(k), you can direct some or all of your salary deferral to the Roth account up to the contribution limits of $18,000 for 2016 and $24,000 for those aged 50 or over. Any employer match must be directed to the traditional account. Even for those who can contribute to a Roth IRA, the Roth 401(k) contribution limits are higher than the $5,500 ($6,500 for those 50 or over) allowed for a Roth IRA.
For those who want to contribute to a Roth, the Roth 401(k) provides a great opportunity to do so.
Taxes Now or Later?
As with a Roth IRA, the decision whether to contribute some or all of your 401(k) deferrals to a Roth is in large part about future taxes.
For those who are earning significant compensation, the current tax breaks from the traditional 401(k) account option can be significant and might outweigh the benefits of tax-free withdrawals down the road.
For 2016, the 28% and 33% marginal tax brackets are:
|Tax Bracket||Single Filers Income Level||Married Filing Jointly Income Level|
|28%||From $91,150 to $190,150||From $151,900 to $231,450|
|33%||From $190,150 to $413,350||From $231,450 to $413,350|
When you add in state income taxes — all but seven states have state income taxes — the benefits of contributing to a traditional 401(k) for those with high incomes on a pre-tax basis becomes very compelling.
This is the classic time value of money problem. The adage “A dollar today is worth more than one in 10 years” holds true. The issue is how much in future tax savings from tax-free withdrawals from a Roth would be enough to offset the current tax savings from contributing to a traditional IRA? What is an appropriate discount rate to use? What assumptions should you use about future tax rates and your tax bracket in retirement?
There are a few calculators out there that can illustrate the benefit of going the Roth or traditional route. When using any of them be sure to check out the underlying assumptions for reasonableness.
On the other hand, those in lower tax brackets might find the benefits of tax savings down the road that come with Roth contributions more compelling than the current tax breaks that come with contributions to a traditional 401(k) account.
Future tax rates are of course unknown. A Roth 401(k) can provide you with a measure of tax diversification as a hedge against the potential of tax hikes in the future.
You can divide your own contributions between the Roth and traditional options any way you desire.
Beyond this, if your prior retirement savings are mostly or exclusively pre-tax in nature, the Roth option allows you to use contributions to give yourself a degree of tax diversification for the future.
The choice of which type of 401(k) account to use is not limited to one or the other. Those who want to hedge their bets can divide their 401(k) contributions between the traditional and the Roth options or go with one or the other exclusively.
For those who are married and have both spouses contributing to a 401(k), this can be split across the two of you, offering more options. This is helpful if one spouse’s plan offers a Roth option and the other’s plan doesn’t.
The fact that Roth IRA accounts are not subject to required minimum distributions (RMDs) offers some excellent planning options when using the Roth 401(k).
Roth 401(k) accounts do require you to take RMDs at age 70½, provided you are working, are a 5% or less owner of your employer and the plan allows for this exception. RMDs from a Roth 401(k) are not taxable, but you will lose the tax-free nature of the account.
The strategy here is to roll over the Roth portion of the 401(k) to a Roth IRA. Roth IRAs have no RMDs. A spousal beneficiary can take the Roth IRA and treat it as his/her own with no RMDs during their lifetime.
Further, the Roth 401(k) option offers the same estate planning opportunities as a Roth IRA if rolled over to one. Non-spousal beneficiaries can opt to stretch out the account just as with an inherited traditional IRA. They will have to take RMDs from the account, but these distributions are not taxable. The amount that remains in the account can continue to grow on a tax-free basis.
For those of you whose 401(k) offers a Roth option, this is another planning option to consider. The Roth 401(k) offers all of the benefits of a Roth IRA but with higher contribution limits and no income ceiling. As with most things in financial planning, whether or not this is the right option for you will depend upon your situation and your goals.