Roth 401(k) Versus Traditional 401(k)
During a recent seminar I was asked: “If I had to choose between saving only in a Roth 401(k) or traditional 401(k), which would I choose?” The following discuss some of the features, similarities and differences between the two retirement plans.
The Roth 401(k) and Traditional 401(k) have the same annual contribution limits. In 2017, you can contribute a total of up to $18,000 a year to a Roth 401(k) or Traditional 401(k), and an additional $6,000 if you are age 50 or older. For tax year 2018, contributions are increased to $18,500. Over age 50 additional contributions remain at $6,000. Unlike the Roth IRA, the Roth 401(k) has no annual income restrictions or limitations. Anyone at any income level can contribute to a Roth 401(k).
The big difference between a traditional 401(k) and a Roth 401(k) is when you pay the taxes. With a traditional 401(k), you make contributions with pre-tax dollars, so you get a tax break up front, helping to lower your current income tax bill. Your savings (both contributions and earnings) grow tax-deferred. When you retire and begin withdrawing money out of your account, every dollar withdrawn (including the growth) is taxable as ordinary income. With a Roth 401(k), it’s basically the reverse. You make your contributions with after-tax dollars, meaning there’s no upfront tax deduction. However, withdrawals of both contributions and earnings are tax-free in retirement.
The conventional approach for deciding between saving in a Roth 401(k) or a Traditional 401(k) is based almost exclusively on one question; what do you think your federal tax rate will be in retirement? If you think your tax rate will be lower in your retirement years than it is now, then you should be saving in a Traditional 401(k). If you think your tax rate will be higher in your retirement years, then you should be saving in a Roth 401(k).
There are two problems with this. The first is that no one knows where tax rates are headed over the next 10, 20, or 30 years. The second is that no one knows what tax bracket they will be in when they retire. The fact is that tax rates have gone up and down dramatically over the years. Current tax rates are low when put in historical context. The accompanying chart shows how much the lowest and highest federal tax brackets have changed over the past 70 years.
Required minimum distributions
The Roth 401(k) and Traditional 401(k) both require account owners to begin taking minimum distributions at age 70?. However you can avoid taking required minimum distributions by rolling a Roth 401(k) into a Roth IRA, which doesn’t have any minimum distribution requirements. You can convert a Traditional 401(k) into a Roth IRA.
To do this you need to pay taxes on the pre-tax contributions and earnings that have been deferred over the years. The amount of savings converted to a Roth IRA would then be added to your current year’s income, which could potentially push you into a higher tax bracket.
Social Security and Medicare
Withdrawals from 401(k) and TraditionalIRA’s are considered taxable income in the year you take them. This increase in income can impact the taxation of Social Security benefits and the amount of your Medicare Part B premiums. Since Roth distributions are tax-free, they are excluded from the formulas that determine Medicare Part B premiums or how much tax is owed on Social Security benefits.
When it comes to having to choose between saving in a traditional 401(k) or a Roth 401(k), I choose the Roth. The Roth essentially removes the uncertainty of future tax rates. With a Roth you know exactly how much you will pay in taxes during your retirement years -- zero percent.
Every dollar of contributions, interest, dividends, and capital gains you withdraw from a Roth, will never be taxed during your retirement years. With a traditional 401(k), you know that 100 percent of every dollar you withdraw in retirement will be taxed. What you don’t know is what that tax rate will be.
Even if your tax rate is lower in the year you retire, it is possible that tax rates could rise in the future. Instead of working the tax system to your advantage by deferring taxes at a high rate during your working years, and paying them at a lower one, you could end up doing just the opposite.
The bottom line is that you’re contributing to a retirement account to make your golden years more affordable, not to give yourself a tax break today.
I would rather pay my taxes now, when I know what my tax rate is, while I am employed and earning a paycheck, rather than paying an unknown tax rate when I am retired, and the paychecks have stopped.
Martin Krikorian is president of Capital Wealth Management, a registered investment adviser providing “fee-only” investment management services located at 9 Billerica Road, Chelmsford. He is the author of the investment books, “10 Chapters to Having a Successful Investment Portfolio” and the “7 Steps to Becoming a Successful Investor.” Martin can be reached at 978-244-9254, Capital Wealth Management’s website, www.capitalwealthmngt.com , or via email at email@example.com .