A study by the Harvard Business School suggests that if you participate in an employer-offered Roth 401(k) plan instead of a traditional 401(k) plan, you will likely have more to spend in retirement. According to the authors of the study, the reason for this has a lot to do with the complexity of the American tax system and its impact on how people save. (For more, see An Introduction to the Roth 401(k)).
The Roth 401(k) Is New
The Roth 401(k) has only been available since 2006, and not all companies offer it. Just like a traditional 401(k) plan, the Roth version is a retirement savings vehicle into which employees make regular contributions. In many cases employers make matching contributions as well.
What’s different with a Roth 401(k) plan is that your contributions are made with after-tax dollars. You get no reduction in your taxable income that year, but when you withdraw funds upon retirement, you pay no taxes, including on any of the money your contributions earned over time.
With a traditional 401(k), your contributions are made with pretax dollars and subject to taxes upon withdrawal. You are taxed on both your original contributions and on all the money those contributions earned.
It’s worth noting that with both a traditional 401(k) and a Roth 401(k) your employer’s matching contributions are made with pretax dollars. Employer contributions to a Roth 401(k) are placed in a separate traditional 401(k) vehicle where contributions and earnings are both taxed on withdrawal at retirement.
Complexity Enters the Picture
As you would not be paying taxes on your Roth 401(k) contributions upon retirement, you could actually contribute less to allow for the fact you are “pre-paying” your taxes. What the Harvard Business School Study found, however, was that – thanks to general confusion about retirement savings in general – most people tend to follow rules of thumb no matter which type of 401(k) plan they have.
In other words people tend to have the same contribution rate with a Roth 401(k) as with a traditional 401(k). The result: The Roth 401(k) translates into more purchasing power once you retire, as all of your contributions plus earnings will be available to you.
Savings Rules of Thumb
Most people follow one of several rules of thumb when saving for retirement. One involves putting in the amount necessary to earn the maximum employer matching contribution. Another is to contribute the maximum amount your plan allows. Another often used ruled of thumb is to simply save 10% of your pretax income.
In all cases – no matter which rule you follow – because you are taking the tax hit now instead of at retirement, by saving the same amount with a Roth 401(k) your “take” on the other end (retirement) will be more.
Additional Arguments for a Roth 401(k)
There are other reasons for considering a Roth 401(k) if your employer offers it.
- Contribution limits are the same as with a traditional 401(k) and more than with a Roth IRA. For 2017 you can contribute $18,000, plus an additional $6,000 if you are 50 or older. (Roth IRA contribution limits are $5,500, with an additional $1,000 contribution allowed if you are 50 or older.)
- Your income doesn’t affect your ability to contribute, as it does with an IRA. As with a traditional 401(k), earners at all income levels can contribute up to the maximum amount allowed. (For more, see Roth 401(k) vs. Roth IRA: Is One Better?)
- A Roth 401(k) is a good idea for young earners in a low tax bracket because paying taxes now will hurt much less than doing so closer to retirement and perhaps even less than in retirement.
- As you won’t pay taxes on withdrawals from your Roth 401(k), you can take out a large amount – for an emergency or other reason – once in retirement without worrying about a big tax bite.
- Funds from a Roth 401(k) can be transferred to your heirs upon your death without a tax penalty. This is a great estate-planning option.
Best of Both Worlds
If your employer offers both a traditional and Roth 401(k), you might want to consider choosing both. The combination of a Roth and traditional 401(k) plan would let you lower a portion of your current taxable income while protecting yourself against a rise in income-tax rates in the future. Keep in mind that your contributions will be combined and subject to the applicable limit ($18,000 or $24,000 if 50 or older.)
If your employer only offers a traditional 401(k) and you are eligible, you may want to consider contributing to the 401(k) at work and adding a Roth IRA of your own. Doing this gives you one additional advantage you can’t get with a 401(k) – the ability to withdraw your original contributions (not earnings) tax and penalty free. (For more, see Can I contribute to both a 401(k) and an IRA?).
The Bottom Line
If you tend to be a rule-of-thumb saver, not interested in potentially complicated tax-rate calculations or just unsure of what those tax rates will be when you retire, you might want to look into a Roth 401(k) plan if your employer offers it. Being aware of the results of the Harvard Business School study should at least inspire you to evaluate your own saving habits to make sure that you are taking advantage of the best opportunity to retire with the most income. As with all things involving money and retirement, consult with a trusted financial advisor before making important financial decisions.