2Q2018 | Ages 30 – 44
To Roth or not to Roth 401k?
As we continue to see more plan sponsors enable Roth as an option for participants, it’s clear that many of you still struggle with the decision – should you defer pre-tax dollars into your account, or contribute on a Roth after-tax basis? I can’t answer that for you, but I can offer some clarity to maybe make the decision a little easier.
On the surface, the Roth question is a simple tax gamble: will my tax rate be higher or lower when I’m retired than it is while I’m working? Most of us have a guess about that – and I encourage you to seek the opinion of a tax professional – but there is no way to be sure when so many variables are out of our control. That brings us to one of the key benefits of Roth contributions: certainty (Disclaimer: as long as the laws don’t change). As an investment advisor, I don’t see much certainty. If you can pay tax today at a known rate (based on expected earnings this year), and that money can grow tax-free… then if you wait until retirement, all of that money (including the growth!) comes back to you as tax-free income, Roth seems attractive.
Many things could change in the decades before you retire, causing you to question your decision along the way. The answer to “Roth or Not” may change over time. Just as we like to position participants with diversity of investments, it’s also important to create diversity of income streams in retirement.
Even if you don’t have much confidence in Social Security, it will likely be a key component of your retirement income. Have you considered that if you defer income today, taxable income in retirement will also affect the taxability of other income streams? Not only could more taxable income bump you up into higher marginal tax brackets, but it could also push your income beyond certain thresholds and increase the percentage of your Social Security income that is taxable. Roth distributions in retirement would not do either. By paying the tax upfront on your contributions, you will have pre-paid your tax obligation to the IRS under current rules. That means when you retire, the IRS will have no reason to track how much you pull out each year to live, and they won’t ever tell you how much you have to distribute. You already paid your tax due on that income in the year you earned it. The growth of Roth is then tax-free.
Here are some answers to common questions that may help you decide “to Roth or not to Roth 401k:”
Q: I’m contributing 10% pre-tax today. What changes if I switch to 10% Roth contribution?
A: By switching all, or some, of your payroll contribution to Roth, the immediate change is that you’ll now see taxes withheld from your paycheck on that amount. So if you are considering increasing your Roth contribution on a tight budget, keep in mind that additional taxes will be withheld today in order to create that tax-free income in retirement.
Q: I’ve read about the Tax Cuts and Jobs Act (TCJA) of 2018. Does that affect my 401k contribution?
A: You’ll recall that many Americans received an increase in take-home pay recently as the IRS adjusted payroll withholding tables to account for tax reform. Now may be a great time to adjust your 401k contribution. Maybe you can increase the percentage you contribute. Or if you embrace the Roth concept, this additional take-home pay could help to account for the increased tax bill in the current year of switching your contribution from Traditional to Roth
Q: If I start contributing Roth, will I have two separate 401k accounts?
A: No. The recordkeeper will combine all of the sources of funds to your account and invest all dollars the same way. You do not need to manage separate investment portfolios. They will simply keep track of how money went into the plan, so that when you start distributing in retirement they can help tell you how the money might be taxed.
Q: My company offers a match. Do I need to contribute Traditional tax-deferred to get the match?
A: In most cases, no. If a match is offered, most plans will honor this regardless of how you contribute. Keep in mind, the company match will always add to your tax-deferred balance. So, if you’re looking to build both buckets of retirement income, taxable and tax-deferred, you would inherently be doing that by a Roth contribution combined with a company match.
Q: I make too much to contribute to a Roth IRA. Can I contribute as Roth to my 401k?
A: Yes. The fact that the IRS limits Roth IRA contributions to those that earn less than a certain amount might tell us something, but that income limitation does not apply to Roth 401k contributions. In 2018, employees your age can contribute up to $18,500 to their 401k. This total can come from Traditional tax-deferred or Roth after-tax contributions, or a combination of the two. Any profit share or match you receive is in addition to this limit.
Confusing. I know. “To Roth or Not to Roth 401k” is a challenging question. Please don’t overthink it. You can always come back to this question and change your answer as your situation changes. The QPA advisors to your plan are excellent resources to help you understand your choices so that you can confidently make a decision that is best for you.
Advisory services offered through Prime Capital Investment Advisors, LLC. (“PCIA”), a Registered Investment Adviser. PCIA: 6201 College Blvd., 7th Floor, Overland Park, KS 66211. PCIA doing business as Qualified Plan Advisors (“QPA”).
This commentary is provided for information purposes only and does not pertain to any security product or service and is not an offer or solicitation of an offer to buy or sell any product or service.