By Eric Reich
The days have long passed since workers had pensions, at least for the average person (15% vs. 80% 30 years ago). Since then, workers are typically defaulted to a 401(k) or similar type of plan. The intent of the change was to shift the burden of retirement planning from the companies to the workers. The early years of 401(k)s, as you can imagine, didn’t go so well. Many people didn’t contribute at all, and if they did, they certainly weren’t contributing enough. Fast-forward a few decades, and workers are starting to embrace the 401(k) as the primary savings vehicle for retirement savings.
Over the years, the 401(k) has been refined and improved by both Congress and plan providers alike. Arguably the best of those enhancements has been the adoption of allowing 401(k)s to have Roth components. Just as a refresher, a traditional 401(k) allows you to defer income into the 401(k) and defer the income taxes on the amount you defer until you withdraw that money some time in the future. Those withdrawals are generally allowed after age 59 ½. The Roth, by contrast, does not provide for an immediate tax deduction, but instead allows not only tax deferral but also tax-free withdrawals in retirement. The same rules of being post-59 ½ generally apply.
So how do you decide which option to take? Well, that depends on a few factors. First, how badly do you need the tax deduction? If you are in a high marginal tax bracket, then that deduction today might be worth more to you than in the future. Second, do you have an idea of what your future retirement income might look like? If so, we can get a general sense of whether or not the tax deduction is better today or later. Lastly, what are future tax rates likely to look like? This is impossible to know so I wouldn’t get too hung up on trying to predict. I always advise clients to “go with what we know”. Assume that the tax rates stay the same. Which option is better?
Where the Roth 401(k) option really shines is both for younger savers, and those who are good savers or covered by good pensions. For younger savers, perhaps those just starting out, they most likely are not at the top of the marginal income tax bracket. Given the particularly low income tax environment we are currently in, a younger worker in a lower tax bracket might not benefit all that much from a traditional income tax deduction. Sure, the deduction is nice, but if your effective tax rate (the actual percentage of tax that you pay relative to your total income after deductions, etc.) is 10-15%, for example, then I’m not sure you got the best bang for your buck on that deduction. By contrast, if that same worker retired with a pension and a large 401(k), etc. then their future income tax liability could be huge. By utilizing the Roth 401(k) option, all of that future income from the 401(k) would be tax-free, which could save them from being in a much higher future tax bracket, thereby saving them a lot of money in taxes relative to choosing the traditional 401(k). Roth 401(k)s also do not have a requirement to take out mandatory distributions like traditional retirement assets do (RMDs).
The more income you think you’ll have in retirement, the better the Roth 401(k) option looks, and the less you make today also strengthens the argument for the Roth 401(k). Lastly, if you intend to leave some or all of those retirement assets to the next generation, the Roth 401(k) is tax-free to them as well. If you fit either of these categories, then you will certainly want to look into picking the Roth 401(k) option over the traditional option. As always, consult your tax adviser for more guidance on your specific situation.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. To view form CRS visit https://bit.ly/KF-Disclosures.
Eric is President and founder of Reich Asset Management, LLC. He relies on his 25 years of experience to help clients have an enjoyable retirement. He is a Certified Financial Planner™ and Certified Investment Management AnalystSM (CIMA®) and has earned his Chartered Life Underwriter® (CLU®) and Chartered Financial Consultant® (ChFC®) designations.
