Traditional Individual Retirement Accounts (IRAs) have been around for over 45 years. First created as part of the “Employees Retirement Income Security Act of 1974 (ERISA)”, Traditional IRAs were introduced as a way to help Americans save on a tax-deferred basis towards their eventual retirements. The basic idea behind the Traditional IRA is, if you are willing to put aside some money now towards your eventual retirement, in return you get a current tax-deduction, ongoing tax-deferral along the way, and then you will eventually pay your taxes when retired and start to withdraw money from the IRA to pay for your living expenses. These days, we basically take the Traditional IRA for granted. Almost everyone has heard of it and it feels as if IRAs have been a part of our financial world forever.
Next up came Roth IRAs. Roth IRAs were introduced and made avaible to Americans as part of the “Tax Payer Relief Act of 1997”, and were named after the senator who first introduced the concept, William Roth (R-Del). In the past 23 years Roth IRAs have become another well-known part our of financial and investing lexicon. While not everyone knows the exact specifics as to how Roth IRAs and Traditional IRAs differ, most people at least know that they both exist and that there is a difference. What is much less well known is that in 2006, through a provision in the “Pension Protection Act of 2006,” the Roth IRA concept and experiment was vastly expanded when it became a permanent option for 401(k) plans as well.
Although the Roth 401(k) feature has been around for nearly 15 years at this point, for some reason it is still not well known to the average investor. The Roth 401(k) did not come into the world with much fanfare or press coverage and more or less snuck its way quietly into our existence. Many employees who have 401(k) plans that allow for Roth contributions are not even aware of the fact. However, just because they came into our lives without much excitement by no means diminishes the important role they can play in our financial lives and wellbeing.
Before we go into the specifies of the Roth 401(k), let’s quickly make sure we are all on the same page as to the differences between Traditional 401(k)s and Roth 401(k)s. This, as it happens, is basically the same as the difference between Traditional IRAs and Roth IRAs. The main difference between Traditional and Roth (for both IRAs and 401ks) is the timing of when you get your tax-break. Traditional 401(k)s give you an immediate or current tax-deduction in the year of contribution, and you only pay income tax when the funds are withdrawn, usually at retirement. Roth 401(k)s, on the other hand, do not provide for any current tax-deduction; instead, your tax-break comes in the future, at the time of withdrawals. If managed correctly, no taxes will be due when funds are withdrawn from Roth 401(k)s.
The obvious question is, “well, which one is best?” Should you use the Traditional or the Roth 401(K)? The answer can be nuanced, but at its most basic level, it really comes down to just one thing—your tax-bracket, both now and in the future.
If you are in a higher tax-bracket now then you will be when you start to withdraw funds from your retirement accounts in the future, then generally speaking, the Traditional 401(k) makes the most sense. After all, you want to get your tax-break when you are at your highest tax rate to maximize that tax break, so receiving a current tax-deduction (Traditional 401(k)) is your best option. On the other hand, if you believe you will be in a higher tax-bracket in the future because you will have more income, and/or less deductions, or because you believe the tax-rates or tax-structure will have changed, then the Roth 401(k) is likely your best option. Again, you want the tax-break when you are earning at your highest rate, and if you think that will be in the future, you would rather pay taxes now at your current rate and get the tax-break later (Roth 401(K)). If, like most people, you have no idea if you will be in a higher or lower bracket in the future, then you might consider diversifying your tax-bet, and putting a portion into both the Traditional and the Roth sides of your plan. As long as you do not go over the total allowable annual contribution limit for your 401(k) (as discussed below), there is no issue with this strategy.
So how do Roth 401(k)s work?
For 2020, those under the age of 50 can contribute a maximum of $19,500 into a 401(k). For those over 50 an additional $6,500 “catch-up” contribution is allowed, for a total maximum contribution of $26,000. If your plan provider allows for both Traditional and Roth contributions, it is up to you to decide which account(s) to use. Or, as mentioned above, you can use both sides of the plan, Traditional and Roth, as long as your total combined contribution does not exceed the limits discussed above.
Many people who have been interested in using Roth IRAs in the past have been dismayed to learn that they earn too much to do so. For 2020, a single individual cannot have a Modified Adjusted Gross Income (MAGI) above $139,000 and still contribute to a Roth IRA. For a married couple, the combined MAGI income limit is $206,000. One of the best things about the Roth 401(k) (as compared to the Roth IRA), is that there are no income limitations. It does not matter how much you earn; you can always contribute to a Roth 401(k), if it is offered by your plan.
Here is an example…Let’s say you earn $100,000 in 2020, and that your plan is to invest $10% ($10,000) into your 401(k) at work. If you use the Traditional 401(k), you get an immediate tax-deduction, so instead of paying taxes on $100,000 of income in 2020, you pay taxes on only $90,000 of income. The $10,000 you put into the Traditional 401(k) will then grow on a tax-deferred basis. Then, when you start to take distributions in the future, all dollars that come out of the Traditional 401(k) will be counted as taxable income at that time.
If you do everything the same as in the example above, but instead, use the Roth 401(k), you would get no immediate tax-deduction. You would pay taxes on all $100,000 of your 2020 income. Your $10,000 contribution would again grow on a tax-deferred basis, but when it comes time for distributions, assuming you had met all Roth eligibility requirements, the distributions would be 100% tax-free.
One more thing to know about Roth 401(k)s: if your employer offers a matching contribution and/or a profit-sharing contribution, it will always be contributed to the Traditional side. So even if you are personally contributing 100% to the Roth side of the 401(k) plan, you could still end up with Traditional dollars in the plan. Currently, employer matching contributions and/or profit-sharing contributions cannot be made to the Roth side of the 401(k) plan.
The decision about when to use a Traditional 401(k), when to use the Roth 401(k), or when to pro-rate your contributions between the two, is a nuanced one and should not be made in a vacuum. This article is meant to give you a basic understanding of the concepts and your available options, and provide you with some nourishing food-for-thought. As always, all financial and tax matters should be discussed with both your financial planner and your tax-consultant before making any final decisions.
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