The 411 on Roth vs Regular 401ks

Traditional 401(k) or Roth 401(k)?

Workers usually don’t know the difference. Yet employers increasingly are asking them to choose. Nearly two-thirds of private-sector employers with Vanguard plans today offer both a traditional and a Roth 401(k) in their employee benefits. Just four years ago, fewer than half did.

For tips on navigating the traditional-vs-Roth decision, we interviewed two members of the American Institute of CPAs: Monica Sonnier is an investment adviser in the Salt Lake City, Utah, area; and Sean Stein Smith is an assistant professor in the economics and business department at Lehman College in New York.

The difference in the two types of plans is the timing of federal income taxes:

• In a traditional 401(k), a worker who contributes to his or her account will see taxable income reduced by the dollar amount of the contribution. For example, contributing 6 percent of a $30,000 annual salary ($1,800 per year) means the worker pays federal income taxes on just $28,200. The taxes will be paid decades later, when the IRS will require the retiree to pay income taxes on the amounts withdrawn from the traditional 401(k).

• In a Roth, a worker pays income taxes on his or her full $30,000 salary, as usual. The 6 percent is an after-tax contribution that does not reduce the tax bill. The benefit will come decades later, because a Roth does not require the retiree to pay income taxes when the savings – including the Roth account’s investment earnings – are withdrawn.

If a retiree is taxed at the same rate as he was taxed as a worker, there is no difference in the after-tax retirement income the two 401(k) plans provide. However, traditional 401(k)s have generally been viewed as more advantageous, because people typically have lower incomes – and lower tax rates – in retirement than when they were working.

But things might also be changing. Over the long-term, increasing federal deficits due to increased spending pressures from popular programs to support aging baby boomers are expected to push up individual income tax rates. When that occurs, many retirees might be better off with a Roth so they won’t be taxed when they withdraw their savings.

Of course, each individual’s or couple’s tax situation is unique. Given all these caveats, here are the accountants’ rules of thumb for deciding between a traditional and Roth 401(k):

Millennials often start with fairly modest incomes after high school or college. For relatively low earners subject to fairly low federal income tax rates, “It would absolutely make sense to start with a Roth,” said Smith, who is 29 years old.

Sonnier agreed that Roths typically make sense for young adults. But she stressed that it’s more crucial that Millennials not procrastinate on saving than on picking the right type of 401(k). “The most important thing is to play the game and do the saving, which most young people don’t do,” she said. “Do it!”

Generation-X workers and couples, now in their 40s, are probably earning more and may be enjoying their peak earning years.  The traditional 401(k) is usually the best option. The reduction in taxable income reduces what has become a considerable tax bite. It makes sense to defer these taxes until retirement, when Gen-X workers can probably expect to have lower incomes – and a lower marginal tax rate applied to withdrawals from their traditional 401(k)s.

Pre-retirees have choices. They’ve probably saved in a traditional 401(k) for decades – Roths are relatively new – and can continue to do so, since they will typically see a drop in their incomes and tax rates when they retire. However, workers in their 50s might want to consider setting aside a bit of their savings in a Roth account.

The reason is that this will provide them with future flexibility as a retiree trying to limit the impact of income taxes, because the income withdrawn from Roths is non-taxable income. “If [retirees] have that tax-free income, they can draw from it if they need to at certain times to offset the taxability of their Social Security, pensions, or the IRS’ Required Minimum Distributions,” Sonnier said.

One downside to having both Roth and traditional 401(k) accounts is that things can get confusing. But for sophisticated savers, Smith recommends reviewing the options with a professional periodically throughout one’s career and particularly as one’s earnings, tax brackets, and circumstances like age or marital status change.

“You don’t have to be on the phone every quarter or every year, but have [the conversation] on a consistent basis so there aren’t any surprises,” he said.

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