“The 401(k) was built on a simple idea. Set aside money from each paycheck to save for tomorrow and get a tax break today. Many workers now have another option: Save the tax break for tomorrow, too.”
The Roth 401(k) is a relatively new retirement savings tool funded with after-tax money and tax-free growth. It’s like the Roth IRA but with an additional benefit: workers may save significantly more than possible in an IRA, and often, there is a company match. A recent article from The Wall Street Journal, “Roth v. Traditional 401(k): Where to Put Your Money for Retirement?” examines the options.
Roths aren’t the best choice for everyone. Deciding how much to fund a Roth versus a traditional retirement account requires calculating your current spending, future taxable income, and some other unknowable factors—like life expectancy. Despite the choice's complexity, it offers the ability to reduce lifetime tax bills and leave more money for retirement and heirs.
The money withdrawn from a Roth can be tax-free, so it’s excellent for supplementing taxable income during years when retirees would otherwise be pushed into higher tax brackets. Starting in 2024, Roth 401(k)s will be exempt from the required distributions with traditional accounts. Roths can be left intact for heirs, although the accounts must still be emptied in ten years.
The best candidates for Roths are those who anticipate they’ll be in a higher tax bracket in retirement than now, which fits younger workers with years of raises ahead of them. For mid-career earners, it can be hard to tell whether they’ll be in a higher tax bracket during retirement. Some sources of retirement income, including Social Security and pensions, can provide some estimates of benefits. It’s still difficult to accurately predict the investment returns used to determine retirement account withdrawals.
How to decide? Start by comparing your current tax rate and the rate you expect to pay in retirement. For younger earners, the math favors the Roth. Some experts say once a person moves out of the 12% bracket, it’s best to start dividing savings between a Roth and a traditional 401(k). One rule of thumb: add 20 years to your age and put this percentage of money you are saving for retirement into a traditional 401(k), with the rest in a Roth.
If someone retires at 60 and their taxable income falls, it can present an opportunity to convert a traditional IRA or 401(k) savings into Roth accounts at a low tax cost.
Another tactic is the mega-backdoor Roth conversion, which can allow high earners to build a nest egg of tax-free retirement savings without giving up traditional 401(k) contributions and the tax breaks from making them.
Other reasons to consider Roth contributions? Your tax rate is likely to stay the same. To move a large amount into a Roth, big savers might want to contribute to a Roth while working and look for opportunities to convert money while temporarily in a lower tax bracket.
If you think tax rates will increase, as when many tax cuts enacted by Congress in 2017 are scheduled to expire, the Roth is a good way to protect from higher tax rates in retirement.
If you want to leave your 401(k) to heirs, they will have ten years before they need to empty the account, with no tax consequences. The tax-free nature of a Roth withdrawal, IRA, or 401(k) makes it well worth considering.
Reference: The Wall Street Journal (September 2, 2023) “Roth v. Traditional 401(k): Where to Put Your Money for Retirement?”