Should you pay higher taxes now or defer until later?

Working families saving for retirement in a 401(k) will be asked to choose: traditional or Roth? Let’s talk about some of the pros and cons, and watch the video at the bottom to see a few case studies that might aid in tax planning and retirement planning.

Roth 401(k) and Traditional 401(k): how are they similar?

• INVESTMENTS: Both options will have the same menu of investment choices. Opting for Roth or traditional will have no impact on the underlying investment options.

• CONTRIBUTION LIMITS: The contribution limits for both plans are identical. People under the age of 50 can contribute $23,000 in 2024, and the limit is $30,500 for those age 50 or older.

• COMPANY MATCH: Regardless of plan, if your employer offers a company match, the amount will not change based on the option you choose. And, if your employer’s plan allows for it, matching contributions can be made to either type of plan. Just remember Roth matching contributions will show up at tax time as earned income.

Roth 401(k) and Traditional 401(k): how are they different?

• CURRENT TAX: Traditional 401(k) contributions are made with pre-tax dollars, which reduces the current year’s tax liability. You won’t see this on your 1040, either. It is deducted from the wages reported on your W-2. Roth contributions, on the other hand, are made with after-tax dollars and without a current year tax deduction.

• CURRENT YEAR’S INCOME: Roth 401(k) contributions are considered income in the current year. Keep this in mind, especially if you are nearing an important threshold. For example, married couples earning more than:

  • $250,000 are subject the 3.8% Net Investment Income Tax,

  • $400,000 will not qualify for the child tax credit

  • $180,000 are phased out of the Lifetime Learning Credit and American Opportunity Credits

  Staying below those thresholds could save you significant money. Deferring income via the traditional 401(k) could help stay below important limits.

• RMDs: Traditional 401(k) assets will be subject to required minimum distributions (RMDs) at age 73 or 75, depending on when the account owner was born. Roth 401(k) assets can remain in the account and are not subject to RMDs.

Income Taxes Rates: how the 401(k) choice influences whether you pay more tax now or later

1. First guesstimate: is income expected to rise or fall?

   Where are you in your career growth? If you reasonably expect household income to rise in future years, the Roth may be the wiser choice, as you will likely take advantage of current tax rates tied to lower amounts of income. What if you think you are near peak household earnings? The traditional 401(k) seems like the better option, deferring income and avoiding higher taxes.

2. Second guesstimate: will tax rates rise or fall?

   I think this is particularly difficult to forecast, but it’s worth spending at least a little time thinking about our current tax environment and whether rates are more likely to rise or fall. See the chart below for historical tax rates in the U.S. While they have been fairly steady since the early 1990s, tax rates were considerably higher during much of the 1900s. Don’t have a strong opinion on future tax rates? No problem. Assuming the status quo seems reasonable to me. What if you believe tax rates have to rise in the future? All other things being equal, that would tilt the scales toward the Roth option, as you would likely prefer to pay tax at today’s lower rates. The traditional option may be more attractive if you believe tax rates will be cut.

3. Third guesstimate: how and when will you need this money to support retirement spending?

   You’ll recall one of the differences between traditional and Roth options has to do with required distributions, or RMDs. Retirees who expect to support spending goals with resources other than 401(k) assets may find the Roth more attractive. Investments can remain in the Roth 401(k), growing tax-free, and ultimately be passed to beneficiaries, who will also enjoy tax-free withdrawals. Here is a mini case study that helps illustrate what those RMDs could mean in terms of taxable income.

Mini case study: Real-World Implications of RMDs

Here is what RMDs could look like for a married couple, using these assumptions:

• Date of birth for both spouses is 1/1/1975

• $500,000 in current 401(k) assets

• $24,000 in annual contributions

• 6% rate of return

• No distributions before the required minimum distributions, which start in 2050 at age 75

Based on these assumptions, the household’s 401(k) accounts will grow to about $3.6 million over the next 26 years, which is when the account owner reaches 75 years old and would be required to start taking money out of the 401(k). The required distributions, using the uniform life table from the IRS, would be about $150,000. And assuming all 401(k) contributions were made before taxes, all of that would be taxable income taxed at ordinary income tax rates!

Tax diversification

Don’t worry if forecasting these variables seems difficult. As Yogi Berra put it, “It’s tough to make predictions, especially about the future.” Diversifying retirement savings across both Roth and traditional 401(k) options can help bring peace of mind when future incomes and tax rates are uncertain. Good tax planning can help. Imagine a household currently in the 24% federal tax bracket. It could make sense to make Roth 401(k) contributions up to a point where they can continue to pay that 24% rate, and then choose the traditional option to defer income that may have otherwise pushed them into the 32% bracket.

Summary

Retirement planning options continue to evolve, and the Roth 401(k) has become an option for more and more people. Determining which is better - Roth or traditional 401(k) - will often come down to the assumptions made around current vs. future income levels, current vs. future income tax rates, and when (or if) retirement savings will be spent down. Sometimes the answer may seem obvious. For those with murkier forecasts, using both options can make sense, too.

Reach out to us if you'd like to talk through your retirement savings options!

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