There are a bunch of misnomers out there when it comes to the question of “How should I contribute to my retirement plan?”. Today we're going to dispel the rumors and make sure you know fact from fiction so you can find the true answers to this pressing question.
First, let's get the biggest misconception out of the way. When I talk to plan participants about the Roth option, I often hear "I can't participate in Roth because of the income limit". Now, if you don't already know this, the Roth IRA imposes an income limit for participating in the account. This means that if you earn more than this income limit, you cannot contribute to a Roth IRA. However, this limit does not apply to 401(k) plans. I always find it curious that the government will not let you contribute the $6,000 maximum to a Roth IRA if you make over the income limit but you can contribute up to the $19,500 limit to a Roth 401(k) regardless of how much you make. So just to be clear, the Roth IRA income limit does not apply to 401(k) plans.
Now, let's differentiate the two methods of contributing to a retirement plan starting with the more popular version, pre-tax contributions. Pre-tax contributions are a method of funding your retirement plan and deferring the taxes until you begin taking distributions in retirement. Since you are deferring the taxes until later in life, all contributions can be claimed as a tax deduction in the year contributed to the plan. For example, if a participant makes $50,000 per year and decides to contribute $5,000 of their pay to the 401(k) on a pre-tax basis, they only pay taxes on $45,000. By contributing to the retirement plan on a pre-tax basis, you are lowering your taxable income. Please note that any distributions made from your pre-tax 401(k) account before reaching age 59 ½ will result in paying taxes and a 10% early withdrawal penalty on the amount withdrawn so you need to factor this into your decision. Finally, you'll notice that I describe this as a tax-deferred program and not a tax-free program. Once you begin withdrawing your savings in retirement, you will begin paying ordinary income tax on the money you contributed as well as the gains on these contributions. So the question is, “Do I pay taxes now or do I pay taxes later?".
If you understand the concept of a tax-deferred program, the Roth method of contributions is just the converse. Instead of deferring your taxes until later in life, you pay your taxes in the year you contribute to the retirement plan under the Roth option. When most of my clients hear this, their first reaction is "Wait, that's exactly what I'm doing right now with my general savings so why would I do the Roth option and tie up my money in a 401(k)?". It's an excellent question and the answer is one of the most underutilized gems in one’s retirement planning strategy. The answer is… the potential for tax free gains. This means that if you contribute to the retirement plan on a Roth basis, although you will pay taxes upfront, you will not pay taxes on your 401(k) withdrawals later in life. Now this can be a very powerful thing. If we think back to our high school days, the concept of compounding interest can be thought of as "interest on interest". This has the potential to make a balance grow at a faster rate than interest that is calculated solely on the principal amount you have contributed to the 401(k). If your Roth contributions of $300,000 throughout the course of your working years can grow to $1 million (for example), you would not pay taxes on the $700,000 in appreciation. Now, I must caution you that this example is purely hypothetical and returns can vary depending on a number of factors and there is always a potential for loss when investing. That said, Einstein coined the phrase “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.”
One of the things you should consider is when deliberating between the Pre-tax and Roth options is when you believe you will be in a higher tax bracket, earlier in life or later in life? Some of my clients are in the beginning of their career and are in a relatively low tax bracket. Some of them believe it makes sense to contribute on a Roth basis and pay a lower percentage in taxes now than they might pay in their retirement years. Likewise, since they have such a long time-horizon until retirement, they also receive the benefit of compounding interest. This is why a lot of younger participants might favor the Roth contribution method. However, I also have many participants who earn a higher income and/or are further into their careers and, therefore, are in a higher tax bracket. These people might favor the Pre-tax contribution method in order to claim the tax deduction this year and potentially take their distributions in retirement when they have fallen into a lower tax bracket. Many of these participants are in their peak earning years and they have a lot of expenses that will not exist in retirement (mortgage, children’s college expenses, travel, etc.). Since these expenses may not exist in their retirement years, they will need less income to fund their cost of living and, therefore, may fall into a lower tax bracket. The thing we have to figure out is "When do I believe I will pay a more in taxes, now or later?".
The good news is that this is not an all-or-nothing situation. Most 401(k) plans allow you to diversify your tax strategy just like you might diversify your investment strategy. This means that your retirement plan may allow you to contribute a portion of your earnings on a Pre-tax basis and another portion of your pay on a Roth basis. Under this strategy, you would have an answer regardless of what happens in the future. If tax rates increase, I’ll draw off my Roth account first as I already paid taxes on this account. If tax rates go down, I’ll draw off my Pre-tax account first as I’ll pay a lower rate than when I was working. People love to talk about not putting all of your eggs in one basket when it comes to investing but people rarely discuss tax diversification.
Of course, this is less of a 401(k) question and more of a tax planning conversation so we always suggest checking with your tax advisor before making your final retirement plan contribution selection. Join is for next week’s class when we discuss how to setup your participants for a more successful retirement through the use of the Auto-enrollment and Auto-escalate features….