A frequent question I get from 401k plan participants is “What type of contributions should I make Bob, Roth 401k contributions or traditional pre-tax 401k contributions?” After reading the results of a study that was recently published in The Wall Street Journal, my answer has changed. Making Roth 401k contributions appears to be better for everyone!

How Roth 401k contributions and pre-tax contributions differ

Traditional pre-tax 401k contributions are made without deductions for state and federal taxes. Contributions and earnings grow tax-free until they are withdrawn. At distribution, contributions and earnings are taxed at the individual’s state and federal tax rates.

Roth 401k contributions are after-tax contributions. They also grow tax-free (along with the associated earnings) until withdrawn. Different from pre-tax 401k contributions, Roth 401k contributions and earnings are not taxed when withdrawn, provided they have been in the plan for at least five years and are paid out due to a distributable event.

The old way of determining how to contribute

Until I reviewed the results of the study, my answer on how participants should contribute would have been to make both traditional pre-tax 401k contributions and Roth 401k contributions. Here’s how I came to that conclusion.

If you believe that tax rates will be higher in the future (and most tax experts do), it would be best to have your contributions taxed now at a lower rate rather than in the future at a higher rate when your balances are distributed. This line of thinking favors making all Roth 401k contributions.

However, the future is uncertain.

Although we are close to historically low tax rates at both the state and federal levels, there is no guarantee that tax rates will be higher in the future (even though the odds seem to favor it). As a result, it appeared to make sense for 401k plan participants to make both Roth 401k and traditional pre-tax 401k contributions in whatever percentages they felt most comfortable (e.g., 5% Roth + 5% traditional 401k or 7% Roth + 3% traditional 401k).

This strategy seemed to ensure that whatever happened with tax rates in the future, participants would benefit with at least a portion of their total 401k account balance.

Results of new Harvard study

The study, produced by researchers at the Harvard Business School, looked at Roth 401k accounts at companies around the country. What they found is important in determining a contribution strategy for participants with the option of making both Roth 401k and traditional pre-tax 401k contributions.

The key study finding was that participants contributed the same percentage amount whether they made Roth 401k contributions or traditional pre-tax 401k contributions. This is important because in the case of Roth 401k contributions, taxes have already been paid. An example may help.

Assume one participant makes 10% traditional pre-tax contributions and another makes 10% Roth 401k contributions for their entire careers. Also, assume that they invest in the same funds and have the same earnings experience. Let’s say they both end up with $1 million at retirement. The Roth 401k plan participant truly has $1 million, however, the traditional 401k plan participant has $1 million minus state and federal taxes. A huge difference.

The study points out that a way for traditional pre-tax 401k participants to make up the difference would be for them to save some of the tax savings each year into an account that would be used to pay taxes when balances are distributed. But no one does that. That is just not how we think.

The Roth promise

Given these study results, it will still be difficult for many participants to make exclusively Roth 401k contributions because they don’t believe the government will maintain the 100% tax-free withdrawal provision associated with Roth 401k balances. In other words, they don’t expect our elected officials to keep their Roth promise.

I believe that if there is a change in the tax code regarding Roth 401k account withdrawals, it is likely that grandfathering provisions will be attached. So building a Roth 401k account balance is probably worth the risk.

If you don’t currently offer Roth 401k accounts in your 401k plan, you should consider adding them, and in-plan Roth 401k account conversions as well. All plan sponsors should consider emphasizing in their education sessions the significant benefits of contributing to Roth 401k accounts.


About the Author

Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or bob@lawtonrpc.com.

About Lawton Retirement Plan Consultants, LLC

Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to 401(k) plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or bob@lawtonrpc.com or visit the firm’s website at: https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.

 Important Disclosures

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice, and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.