Over the past decade, 401(k) plans have come to more closely resemble the Individual Retirement Account (IRA) in terms of the ways to make contributions to the accounts. And investors need to better understand the tax implications of their choices.
Many employers now offer employees two choices for contributing to their 401(k) plans. Contributions to a traditional 401(k) plan are called “pre-tax” contributions because they are deductible from your taxable income. These contributions grow on a tax-deferred basis but withdrawals of both contributions and earnings are fully taxable as ordinary income.
The second type of contribution is a Roth 401(k) option. In this case, the employee is able to make “after-tax” contributions that are not deductible from taxable income. These contributions and the earnings on them are tax-free when withdrawn from the Roth 401(k). Additionally, unlike Roth IRAs, there is no income limit on Roth 401(k)s, so higher-earning individuals can also contribute to them.
Employees are able to contribute to either or both during the year. The only limit is the overall 401(k) contribution limit, currently $18,000 for 2016. Individuals over age 50 can contribute an additional $6,000. Choosing between a traditional and Roth 401(k) is essentially a bet on how your future income tax rate will compare to your current rate. A traditional 401(k) offers a tax benefit today in exchange for future taxable income. A Roth 401(k) is the opposite—a tax cost today in exchange for tax-free income in the future.
Deciding which tax benefit is more valuable to you requires comparing the tax rate today to the tax rate in the future. In general, if the tax rate during the withdrawal period is higher than the current rate, the Roth 401(k) is the better option. If the current tax rate is greater, then the traditional 401(k) is the better option.
While it may be difficult to predict future tax rates—something we as individuals have little or no control over—it may be more feasible to predict future income levels. For a married couple in their early 50s who have a combined taxable income of $250,000, which puts them currently in the 33% tax bracket, an $18,000 traditional 401(k) contribution will save them $6,000 in federal income taxes. If they believe their future retirement income will be less than $150,000, which would put them in the 25% tax bracket, then that up-front tax deduction seems to be the way to go.
However, a younger couple with combined taxable income of $80,000 will be in a lower 25% tax bracket. A $10,000 traditional contribution will result in a $2,500 federal tax reduction. If at retirement they are earning $160,000 or more annually, they will be in a higher tax bracket and will pay more than the
$2,500 they saved when making the contribution. In that case, forgoing the current tax deduction and opting for future tax-free income might be the better choice.
There are other factors to consider in this decision. The up-front tax deductibility of the traditional 401(k) may allow for higher contributions than the individual may otherwise be able to make. An $18,000 contribution will only reduce tax-home income by $12,000 ($18,000 minus $6,000 in tax savings). It may be advantageous to save the higher amount, take the tax deduction now and worry about future taxes in the future. Another consideration is paying more taxes later (traditional) may be better than paying more taxes now (Roth) due to the time-value of money.
Like many other financial decisions, the traditional 401(k) vs. Roth 401(k) choice, must be made in the context of one’s unique financial situation. It is something we speak to clients about when reviewing their financial goals and objectives.
Have a great month. Happy Father’s Day to all dads and grandfathers. Have a safe beginning to the summer.