A Little History
The Roth IRA was originally proposed by Senator Bob Packwood of Oregon and Senator William Roth of Delaware in 1989. Eight years later, the Roth IRA was established through the Taxpayer Relief Act of 1997.
On January 1, 2006, the Internal Revenue Service (IRS) authorized use of the Roth feature in 401(k) / 403(b) plans. This combines the benefits of a traditional 401(k) plan with those of a Roth IRA. Once adopted by a plan sponsor, participants can choose the Roth tax treatment for all or part of their retirement plan savings.
Roth IRA vs. Roth 401(k)
The main difference between a Roth IRA and a Roth 401(k) is how the money is taxed. With a traditional 401(k), contributions are made with pre-tax dollars, reducing the taxes paid today. The pre-tax dollars are invested and grow tax-deferred. When a participant retires and begins drawing on their 401(k), the money is taxed at their income level in retirement. The idea behind a traditional 401(k) is: 1) people will save more because they won’t pay taxes today; and 2) their income will be lower in retirement than during their working years. What has been shown over the years is that these two assumptions (especially the second) are not always true.
To better understand how these plans work, let’s consider some hypothetical participants:
Joe is a successful VP who is behind on his retirement savings. To course correct, Joe is saving more and living below his means so he can maximize his 401(k). He also anticipates living on 75% to 80% of his current income in retirement. Joe would likely benefit most from a traditional 401(k). He would pay lower taxes on today’s dollars, and because his income would be lower during retirement, he would pay future taxes at a similar or lower bracket.
Clare is a 25-year-old college grad who just joined the workforce. She potentially has 40 years to save and expects that her income will increase over the years. She also anticipates that her retirement income will be greater than it is at her entry-level job. In this case, Clare would likely benefit from a Roth 401(k). She would pay taxes at possibly the lowest tax bracket she’d ever experience. Plus, she would be able to take advantage of 40+ years of investment growth and have tax-free access to her funds during her retirement years.
Sue is approximately 10 years away from retiring. She is an executive at her organization and has reached her highest income. Her expenses are relatively low and her home is almost paid off. Her level of discretionary income is at an all-time high. Sue has also been a diligent saver, always contributing enough money to receive the full 401(k) plan match. She recently increased her savings rate to 10%. Sue is a perfect example of someone who could benefit from a Roth 401(k) for the following reasons:
- Sue has all of her savings in a pre-tax account, which will be taxed during retirement. While Sue does expect her income to decrease during retirement, she isn’t sure how much (especially in the first few years). Sue could benefit by diversifying her income sources during retirement so that she has money that is taxable and tax free. This could help her reduce her taxable income.
Retirees are typically on a fixed income and taxes can take a big bite out of that money. In Sue’s case, she is still working. She hopes to retire in 10 years, but that number depends on health and other circumstances. Because Sue has a steady income, it may be advantageous for her to use a Roth 401(k) and pay some of her taxes today instead of during retirement.
Bill believes that taxes have nowhere to go but up (and he may be right). If this holds true and he won’t be in a lower tax bracket during retirement, it could be in his best interest to pay taxes today. While it’s virtually impossible to predict tax rates in 10 to 15 years, this is a sentiment felt by many people. A Roth 401(k) may be the best fit for someone of this mindset.
Additional Pros and Cons
There are a few more benefits of the Roth 401(k) that weren’t covered in our scenarios. One is the amount of money participants can save. In 2019, a person can save up to $6,000 in a Roth IRA. The cap is $19,000 in a Roth 401(k), and participants 50 years or older may add another $6,000 in catch-up contributions.
Unlike a Roth IRA, there are no income limitations in a Roth 401(k). For single filers, the income threshold to contribute to a Roth IRA starts at $122,000. The allowable contributions gradually reduce until reaching $137,000, at which point a person is not able to contribute to a Roth IRA. For those married and filing jointly, the income threshold starts at $193,000 and caps out at $203,000. Therefore, high-income earners may not qualify for a Roth IRA. There are no income limits in a Roth 401(k), so high-income earners can take advantage of Roth contributions.
Some potential drawbacks do exist with the Roth 401(k). If retirement income is going to be lower than it is today, then it probably makes more sense to use the traditional method. Based on plan participation and industry statistics, the majority of participants are not saving enough to match or exceed their current income. Therefore, the Roth option is not in the best interest for most. This is especially true given the tax implications. Because a participant is saving with after-tax dollars in a Roth 401(k), this means they see a dollar-for-dollar reduction in their paycheck versus a reduced deduction via the traditional method. To illustrate, a person who is saving $100 per paycheck may only see $70 to $80 deducted from their take-home pay due to the pre-tax benefit of a traditional 401(k). In a Roth plan, a person saving the same $100 will see the full amount deducted from their take-home pay.
Best for Some, Not for All
As more participants (especially from younger generations) learn about the benefits of the Roth 401(k), we expect its popularity to grow. Whether or not this savings tool is a good fit for you depends on many factors. We urge you to consult a retirement plan specialist who can evaluate your individual situation. A close look at your present income, current savings, potential earnings and tax appetite should reveal what savings path is best for you.
401(k) & 403(b) Advisory are offered through our affiliate company, SilverStone Asset Management. Visit silverstoneassetmanagement.com to learn more.
This article originally appeared in the 2019 | ISSUE ONE of the SilverLink magazine, under the title “Saving Strategies: Is a Roth 401(k) Right For Me?” To receive a complimentary subscription to the SilverLink magazine, sign up here.