It’s often a debate around the office. A decade has passed allowing participants to leverage Roth 401(k) provisions, provided their qualified retirement plan allows for it. But is this the right choice?

A Roth 401(k) contribution differs from a traditional 401(k) contribution because traditional 401(k) contributions are deposited on a pre-tax basis from pay and taxed when you distribute your account.  Conversely, Roth 401(k) contributions are taxed at the time of contribution and qualified withdrawals are tax-free.

Roth 401(k) contributions tend to be appropriate for participants who want tax-free withdrawals in exchange for paying taxes on contributions. Traditional pre-tax contributions are preferable for participants who seek the upfront benefit from tax-deductible contributions and who pay taxes on withdrawals instead. The upside of the Roth 401(k) is years of tax-free, instead of tax-deferred, growth. The downside is the fact that you have to pay the income tax on the amount you contribute upfront, whereas with a pretax 401(k) you pay income tax when you distribute funds in retirement.

What is a qualified withdrawal? To make a "qualified" withdrawal from a Roth 401(k) account, the account holder must have been contributing to the account for at least the previous five years, and be either 59 ½ years old, deceased, or completely and permanently disabled. In the case of being deceased, the funds would go to the deceased beneficiaries.

What is a Roth In-Plan Conversion?

An in-plan Roth conversion permits participants to transfer the non-Roth portion of their retirement account into a designated Roth account within the same plan, even if the amount is not otherwise distributable. The amount converted becomes subject to federal income tax in the year of the conversion, but qualified distributions from the Roth account in the future are entirely income tax free. The difference between an In Plan "Rollover" and In Plan "Conversion/Transfer" is that the rollover is for amounts that would otherwise be eligible for distribution from the plan, while the conversion/transfer is for amounts not eligible for distribution.

Is Roth the right choice?

Even though this feature has been around since 2006, many employers and participants still haven’t been educated on its benefits and pitfalls. Tax-free withdrawals could be a significant benefit, especially if you expect to be in the same or a higher income tax bracket at the time of withdrawal than you are in at the time of your Roth contribution or conversion to Roth.

Participants should consider Roth 401(k) as an option if they expect their tax rate in any given year to be the same or higher in the future, are interested in tax diversification, or are planning to leave funds as part of an inheritance strategy for their spouse or children.

Many of the common pitfalls we observe include participants making Roth contributions and expecting to be in a lower tax bracket when they retire, participants who need access to funds before the next five years, and, what I believe to be the biggest problem, participants who fail to analyze each year’s contribution to determine the advantages of being taxed at a lower rate now (or not taxed at all) versus at a higher rate in retirement. Every year must be examined to make the appropriate decision.

Participants should be educated, leverage the tools available to them through their plan providers and seek guidance each year from their tax specialist when making decisions for Roth contributions and Roth conversions. Roth is not for everyone, but there is a common and valid argument for the benefits of tax diversification.

For more guidance on Roth, contact us today.

LinkedIn

Related

Total Rewards: Compensation and Benefits Do You Have Health Savings FOMO?