Saving for retirement can put you on the path to true financial independence. With rising concerns about the solvency of Social Security beyond 2037 and the savings burden placed on individuals, choosing to participate in an employer-sponsored 401(k) plan can have a positive impact on your future retirement preparedness.1 But you have another critical decision to make after choosing how much to contribute to the plan: whether to contribute to a traditional 401(k) or a Roth 401(k).
If you take the time to understand the differences between a traditional and a Roth 401(k) and identify the contribution limits, you can decide whether a Roth 401(k) makes sense for you and can potentially reduce your total lifetime income taxes. More importantly, you will be taking a proactive step toward planning for your retirement.
Overview of Traditional and Roth 401(k) Accounts
Whereas traditional plans are funded with pre-tax dollars (dollars that have not yet been taxed), designated Roth contributions are made to a separate Roth 401(k) account that allows you to contribute after-tax dollars that are taxed now.2 Choosing whether it makes sense for you to receive the tax savings now or later is a big part of the traditional vs. Roth 401(k) decision.
Traditional 401(k) plans help lower your taxes now. However, you will have to pay taxes on the contributions and investment earnings when you start taking money out in retirement. With a Roth 401(k), the income tax breaks come later. You can make tax-free withdrawals of contributions and earnings in the account during retirement provided that the distributions are qualified—that is, you’ve had the account for at least five years and the distributions are made after you reach age 59.5 or you have a disability.
Traditional and Roth 401(k) Limits
How much you can annually contribute to a Roth 401(k) is the same as it is for a traditional 401(k). In 2020, you can contribute up to $19,500 to a 401(k), including pre-tax and designated Roth contributions.
If you are age 50 or older, you can contribute an additional $6,500 in catch-up contributions. These figures represent a slight increase from the 2019 traditional and Roth 401(k) limits of $19,000 (and $6,000 in catch-up contributions for those 50 or older).2
You can contribute to both a Roth 401(k) and a traditional 401(k) as long as your combined contributions do not exceed the annual 401(k) contribution limits.
Roth 401(k) vs. Roth IRA
It is also important to note the similarities and differences between a Roth 401(k) and a Roth Individual Retirement Arrangement (IRA). Roth 401(k) accounts and Roth IRAs both offer tax-free withdrawals of contributions and earnings for qualified distributions. However, the Roth IRA contribution limit is significantly lower than the Roth 401(k) limit: $6,000 in 2020, or $7,000 if you’re aged 50 or older.2
Moreover, Roth IRAs are subject to income limitations. For example, in 2020, single individuals with a modified adjusted gross income (MAGI) of $139,000 or more are ineligible to contribute to a Roth IRA, as are couples filing jointly with a MAGI of $206,000 or more.3 Unlike Roth IRAs, your ability to contribute to a traditional or Roth 401(k) is not affected by your income because 401(k) plans are not subject to income limitations.
A first-time home purchase counts as a qualified distribution for a Roth IRA.
Deciding on Roth 401(k) Contributions
Follow these steps to determine whether designated Roth contributions can help you meet your financial needs in retirement.
Identify the Plan Type That Your Employer Offers
First, check whether your employer offers a Roth 401(k); this account only took effect in 2006 and isn’t offered by all firms.4 Approximately half of all plan sponsors now offer a Roth option.5 If you have a Roth 401(k) available, assess whether the Roth account provides similar features as the traditional 401(k), such as automatic enrollment.6
Also, understand how your company’s matching contributions work (if your employer offers a match). Many employers give you an incentive to participate in a 401(k) plan by matching your contributions; consider contributing at least as much as needed to maximize your 401(k) match. If you have a company-provided match, your employer is allowed to make matching contributions even if you elect to participate in a Roth 401(k). However, the company match must be made to the designated Roth 401(k) plan. Moreover, a matching contribution to a Roth 401(k) is considered a pre-tax contribution. This means that matching funds and the investment growth of these funds will be taxed as ordinary income when you begin taking distributions at retirement.7
Some employers offer an after-tax 401(k) contribution option, but this can differ significantly from a Roth 401(k) and shouldn’t be confused with a Roth 401(k).
See If Lowering Your Income Qualifies You for Tax Breaks
In many cases, the simple act of reducing your adjusted gross income (AGI) can make you eligible for tax credits and other tax breaks. For example, the Retirement Savings Contribution Credit, also known as the Saver’s Credit, is not available if your AGI is above $65,000 as a married couple filing jointly, $48,750 as the head of the household, and $32,500 for all other filers (single or married and filing separately).8
Since contributing to a traditional 401(k) lowers your taxable income, it can help you get a larger tax credit if your income is slightly above these limits. Paying attention to your adjusted gross income and lowering it when possible can also make you eligible for a Roth IRA or fully tax-deductible contributions to a traditional IRA.9
Assess Whether You Want to Pay Taxes Now or Later
Trying to navigate the complicated income tax code in the U.S. can make the Roth vs. traditional 401(k) decision-making process seem complicated. But it all comes down to whether you want to pay taxes now (Roth) or at the time you withdraw the money (traditional). Deciding the best option for you requires a little retirement planning to determine when you think you will be in the highest marginal tax bracket.10
If you are in the early stages of your career and are currently in a lower income tax bracket, the Roth option is appealing. You can lock in known income tax rates today that could be lower than your future income tax bracket during retirement when you will need your retirement savings. However, if you are in your peak earning years and nearing retirement, it likely makes more sense to take the tax breaks today with a pre-tax traditional 401(k) contribution. As a result, you will benefit from paying income taxes at a lower tax bracket during retirement rather than during your high-income years immediately before leaving the workforce.
Ask Yourself Questions About Your Financial Future
It can be challenging to make the Roth vs. traditional 401(k) decision when future income tax rates are uncertain. Instead of relying on a fortune teller to predict tax rates years from now, ask yourself the following questions to help you decide.
How likely is it that your income will increase between now and retirement?
Seriously consider your future earnings potential when making the Roth vs. traditional 401(k) decision. If you are at or near your peak earning years right now, you may want to stick with pre-tax 401(k) contributions. But if you anticipate your income increasing, you will likely see your income tax bracket increase. This could bump you into a higher tax bracket and would, therefore, make the Roth option more appealing.
Do you plan on working during retirement?
You may not see any big changes in your income tax bracket if you plan on working into traditional retirement years. The result of this might be that you remain in the same tax bracket. Usually, if your tax bracket is the same at retirement, you will see equal benefits with a Roth 401(k) compared to a traditional 401(k). But consider keeping some money in a Roth account to avoid seeing your income taxes creep into a higher marginal tax bracket.
Similarly, most retirees in the U.S. end up with an income-replacement rate during retirement that is lower than their income while working.11 But if you think your income will be higher in retirement, the Roth 401(k) could make more sense because you won’t owe taxes on qualified Roth 401(k) distributions.2
Will you be retiring during a period of higher income tax rates?
If you’re worried about higher taxes across the board as a result of the current political and economic landscape, consider going with a Roth 401(k). But keep in mind that just because income tax rates may increase, that doesn’t necessarily mean your tax rate will be significantly higher.