How to Choose Between a Roth or Traditional 401(k)
Roth IRAs receive a lot coverage in the financial press but surprisingly the Roth 401(k) option offered by an increasing number of employers does not. A Roth 401(k) offers a number of potential advantages, but may or may not be the right answer for a given client. As their financial advisor you can help guide them to the best answer for their situation.
Roth Contributions for High Earners
One distinct advantage for high-earning clients who would like to contribute to a Roth account, but who earn too much to contribute to a Roth IRA, is that there are no income limits pertaining to a Roth 401(k). Typically, they can make 100% of their deferral contributions to the Roth option if they so desire. Any employer matching must go to their traditional 401(k) account, however. (For more, see: Top Tips for Managing Old 401(k)s.)
Additionally, even for those who fall within the income requirements, the annual contribution limits of $5,500 ($6,500 for those 50 and over) on a Roth IRA can be an issue. Unless there are rules to the contrary for an individual plan, the contribution limits would be the full amount of the allowable salary deferral which is $18,000 and $24,000 for those 50 and over in 2016.
Tax Breaks Now or Later?
The central question between a traditional 401(k) contribution and making one to a Roth 401(k) is where you will be tax wise in retirement. Is a tax deferral today via contributing to a traditional 401(k) account worth more than the ability to withdraw Roth funds tax-free in retirement? As their financial advisor, you are uniquely qualified to help your clients answer this question. (For more, see: Top Tax Strategies for Retirement Planning.)
For high-earning clients the present day tax benefit can be significant. A client earning $250,000 annually is in the 33% marginal tax bracket for federal taxes. Add to this any state income tax and the tax benefit of a pre-tax 401(k) contribution is pretty significant to them. The 33% tax bracket current extends to income levels of $413,350 for those who are married and filing jointly in 2016. This means that in order for the tax-free withdrawal of a Roth account to be more advantageous, this worker and their spouse would need have an income of greater than $413,350 in retirement. While these numbers are based upon today’s rules and things could change it still seems unlikely that this person will be in a higher tax bracket in retirement. While many clients may not see a drop in their tax rates in retirement, a high-earning client like this likely will.
Younger clients and/or those earning less money might see a bigger benefit to going with the Roth. If they are diligent retirement savers over the course of their career they might find themselves in a higher tax bracket in retirement. And if their situation changes so can their 401(k) election.
Estate Planning Options
One of the reasons that people do conversions from a traditional IRA to a Roth, including the back-door Roth conversion, is for estate planning purposes. Non-spousal beneficiaries receive Roth IRA accounts tax free and withdrawals from the account are also tax-free. For clients with these types of estate planning needs and desires, directing some or all of their salary deferrals to a Roth 401(k) can make sense. This might negate the need to do a taxable Roth conversion, or at least reduce the amount that is needed to convert. (For more, see: 5 Ways Your Clients Can Shrink Their Tax Footprint.)
In order to take advantage of these estate planning benefits it is better if your client were to ultimately roll their Roth 401(k) to a Roth IRA. This can be done at retirement or before if the client doesn’t roll their account into a new employer’s plan upon changing jobs. As with the decision as to whether a Roth 401(k) is better from a long-term tax perspective, deciding upon whether a Roth contribution for estate tax reasons is a good idea is a decision where you will need to run the numbers for your client looking at their overall situation.
We have no way of knowing what the future holds in terms of future tax rate changes. Will rates increase over time? A Roth 401(k) can help clients hedge their bets and provide some level of tax diversification for them. Contributions can be divided between the Roth and traditional 401(k) options. As mentioned, any employer matching contributions will be made to the traditional 401(k) option. (For more, see: Tips for Tax-Efficient Retirement Plan Withdrawals.)
Tax diversification can also extend beyond the client’s 401(k). Contributions can be directed to the Roth option here if the client has no outside Roth money, for example.
The Bottom Line
The Roth 401(k) option is being offered by an increasing number of 401(k) plan sponsors. A key advantage for those who wish to contribute to a Roth account is the fact that there are no income limitations as with the Roth 401(k) and that they can generally contribute the full amount of their salary deferral to the Roth option. As an advisor to your clients you can help them determine if directing some or all of their contributions to the Roth option in their employer’s plan makes sense for them. (For more, see: How Much Should Retirees Withdraw from Accounts?)