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?”
It now appears that everyone would be better off making Roth 401k contributions only. Here’s why.
Roth 401k Contributions Only
The difference between Roth 401k and pre-tax 401k contributions
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 Contributions and earnings grow tax-free until they are withdrawn.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, which is normally at retirement, 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 They also grow tax-free (along with the associated earnings) until withdrawn. Different from pre-tax 401k contributions, Roth 401k contributions and earnings are not taxed when withdrawn, provided they have been in a 401k plan for at least five years and are paid out because of a distributable event.
The old way of determining how to contribute
Historically, the logic used to determine whether you should make traditional pre-tax 401k contributions or Roth 401k contributions and how much of each, flowed like this.
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 more Roth 401k contributions.
Also, the younger you are, the more it makes sense to make a greater percentage of your 401k contributions Roth 401k, for two reasons. Younger workers have a longer period of time over which their balances can grow tax-free and they are probably in a lower tax bracket, making the tax savings of traditional pre-tax 401k contributions less valuable.
However, the future is uncertain.
Although we are at historically low tax rates at 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 most 401k plan participants to make both Roth 401k and traditional pre-tax 401k contributions in varying levels based upon their ages.
Younger workers might be better off making a higher percentage of their total contributions Roth 401k. For example, if you contribute 15% of your salary to a 401k plan, maybe make 10% Roth 401k plus 5% traditional pre-tax 401k.
Older workers may benefit most by contributing in just the opposite way. Let’s say 10% traditional 401k pre-tax contributions plus 5% Roth 401k. Middle-age workers might be best served by making half of their total contributions Roth 401k and half traditional pre-tax 401k.
This strategy tried to ensure that whatever happened to tax rates in the future, participants would benefit with at least a portion of their 401k account balance.
Results of a Harvard study
A recent study, produced by researchers at 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 15% traditional pre-tax 401k contributions and another makes 15% Roth 401k contributions for their entire careers. Also, assume that they invest in the same funds and have the same earnings experience resulting in the same $1 million balances at retirement.
The participant who made only Roth 401k contributions truly has $1 million; however, the participant who made only traditional 401k plan contributions has $1 million minus state and federal taxes. A huge difference.
The study points out that a way for traditional pre-tax 401k contributors to make up the difference would be for them to save some of their tax savings each year into a taxable savings account that would be used to pay taxes when 401k plan balances are distributed. But very few people would do this. It is just not how we think.
Most experts agree that tax rates are at historically low levels, especially federal tax rates. It would seem that they couldn’t go much lower.
Unfortunately, our country has a number of problems that don’t appear to be solvable without raising taxes. Social Security always seems to be on the verge of bankruptcy and will need to be fixed at some point in time.
Medicare needs bolstering and could potentially evolve into Medicare for All, likely resulting in higher taxes for all. And if our lawmakers are ever responsible enough to balance the budget, they will likely do so, at least partially, via a tax increase.
Finally, President Donald Trump’s 2017 tax cuts are set to expire after 2026 unless Congress decides to make the tax reductions permanent.
It seems easy to conclude that tax rates, at least at the federal level, have no-where to go but up.
The Roth promise
In its quest to find new revenue to solve any or all of these problems, Congress could consider taxing retirement benefits in some way. Many tax experts point to the possibility of future taxation of Roth balances. Is that likely? At least one expert doesn’t think so.
Michael Kitces wrote a great blog piece about why he thinks the Roth 401k promise will stick. And he is very convincing.
He believes that one of the biggest reasons the federal government will keep its Roth 401k promise is because unwinding it and taxing balances does not produce enough tax revenue. All revenue-raising proposals are scored by the Congressional Budget Office on their ability to produce revenue. Taxing Roth balances just doesn’t score high enough.
The second major reason that Congress won’t go back on its promise, according to Kitces, is that breaking it affects older folks and retirees to a great extent. And older folks vote!
In addition, I believe that if there is a change in the taxation of Roth 401k account withdrawals, it is likely that grandfathering provisions will be attached for those close to retirement.
All appear to point to one conclusion
The Harvard study, current tax rates and a future that appears to require higher taxes all point to one conclusion: Workers should make Roth 401k contributions rather than traditional pre-tax 401k contributions beginning as soon as possible.
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 making Roth 401k contributions so participants can understand the tax impact of their 401k contributions.
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 email@example.com.
Lawton Retirement Plan Consultants, LLC (LRPC) 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 employer retirement plan sponsors. The firm specializes in Socially Responsible Investment (SRI) strategies for retirement plans and is a pioneer in the field. LRPC currently has contracts in place to provide consulting services on nearly a half billion dollars in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or firstname.lastname@example.org or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
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, a 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.