If your employer offers Roth or Regular 401k contribution options, which should you choose?
Regular 401k contributions are the default option. These contributions are made on a pre-tax basis, meaning you don’t pay federal income tax on them. (You still pay FICA taxes on them.) When you take a distribution from your 401k in retirement, these contributions and all of their earnings will be subject to regular income tax. Regular contributions are also subject to Required Minimum Distributions (RMDs) in retirement and affect your Medicare premium Income Related Monthly Adjustment Amount (IRMAA).
The other option is Roth 401k contributions. Not all employers offer this, but many do. Roth 401k contributions are made after-tax, but all of the contributions and earnings are tax-free when distributed in retirement if you meet the requirements. Roth 401k assets are not subject to RMDs. And because retirement distributions from Roth 401k are tax-free, they don’t affect your IRMAA calculation either.
How do you decide between Roth or Regular 401k contributions? There can be several good reasons to change from the default regular contribution to Roth. We suggest that you consider a few factors.
#1: You determine that you are in a lower tax bracket now than you expect to be in retirement.
For this question, it’s important to look at your marginal tax bracket, not your average tax rate. Marginal tax bracket is the percentage you pay on the last dollar of income. If you are currently in the 12% or 22% tax bracket and you expect to be in the 24% bracket in retirement, making all of your 401k contributions as Roth is a no-brainer.
Unfortunately, it’s not always easy to predict this scenario. However, there are some generally easier times than others to identify that it’s likely. If you’re at the beginning of a typically high earning career and your income is lower right now, you are likely to be in a lower tax bracket than you may be in retirement. Physicians in residency and attorneys in their first few years out of law school are typical examples of this situation. If you have been a high earner but go through a low income year or two during a career transition or business start-up, this scenario also likely applies to you. Also, just generally, in your 20s, income can often be lower than it will be later on.
Beyond these more obvious times, financial planning software can be a big help. Estimating all of your assets, savings levels, planned retirement age, and planned spending level in retirement can allow us to develop a pretty good estimate of your marginal retirement tax bracket. These projections can also show when your income will trigger the IRMAA which effectively increases your marginal tax rate. This knowledge can then guide the Roth or Pre-tax (regular) contribution decision. The giant caveat to this analysis is changes in tax law.
#2: You’re maxing out your 401k and other tax-advantaged savings vehicles (like HSAs, IRAs, and governmental 457 plans).
If you’re already contributing the most you can to these plans, switching from Regular pre-tax contributions to Roth for your 401k can increase your effective after-tax savings rate. For example, you’re in the 32% tax bracket and you put $24,500 into a 401k. This costs you $16,660 after tax. Instead, if you contribute the full $24,500 to Roth, it costs you $24,500. So you just effectively contributed $7,840 more because you paid your taxes on the contribution (and all the future growth) on the front end.
We wouldn’t encourage you to automatically switch all of your contributions to Roth because of this logic. If the financial planning software projections mentioned above show that you’re in the 37% tax bracket now and are projected to be in the 12% or 22% in retirement, it’s pretty hard to justify paying taxes at the 37% tax rate today. You would be better off doing the pre-tax contributions and contributing the tax savings into a taxable brokerage account. But there are lots variations in between where it’s not so clear cut. This is where looking at the totality of the situation and your goals can lead you to the right decision.
#3: Tax Diversification with Roth and Regular 401k contributions
If you’ve accumulated a lot of assets in the regular pre-tax bucket without much in the Roth or taxable category, getting some diversification can be a good idea. Because we don’t know what future tax rates will be or even all the forms that taxation could take, diversifying is prudent. It can also be especially helpful in retirement when you want to incur a large lump-sum expense. You may want to take a large vacation, buy a new car, or make some home renovations. If you only have access to pre-tax assets, the tax cost could quickly jump into a higher marginal tax bracket. However, if you have access to some Roth assets, you could choose that year to use some of them up to avoid incurring the higher marginal rate.
#4: Increase the After-Tax Value of Your Financial Legacy to Your Heirs
The last reason to make Roth rather than Regular 401k contributions is increasing the after-tax value of any inheritance you leave to your kids. Roth assets can continue growing tax-free for 10 years after you and your spouse are deceased. Consider making contributions to Roth when you and your spouse are in your 20s. You live into your 80s. Your spouse lives into her 90s. Your kids don’t have to distribute the inherited Roth IRA account for 10 years after her death. That provided 80 years of tax-free growth. $10,000 saved in your 20s with a 7% average return could yield $2.2 million tax-free for your kids to inherit. The power of compounding is truly astounding.
The flip side of this argument should also be considered. What if your beneficiaries are charities rather than people? A charity doesn’t pay taxes on the gift regardless of whether it’s from a Roth account or a Regular pre-tax account. So you paying the taxes up front did them zero good. The only way Roth benefits you in this situation is if it reduces taxes during your lifetime. And, we need to keep in mind that you can also gift from Regular pre-tax assets after they’re rolled into an IRA through Qualified Charitable Distributions (QCDs) to reduce or eliminate the tax effect of RMDs during your lifetime.
Our goal for this blog was to share the factors and calculations involved in making the Roth or Regular 401k contribution decision. If you fell into one of the clear-cut categories, wonderful! If not, we’re happy to help analyze and discuss the best option for your situation.
Jean Keener, CFP®, CRPC™ provides fee-only, as-needed financial planning and investment advice. She works with clients of all ages but spends the majority of her time with those in the pre-retirement and retirement years. Jean focuses on helping people make the best decision for their situation about retirement, investments, taxes, and other financial considerations.