To Roth or Not to Roth (401k)?

A common sentiment among investors is to always contribute towards a Roth account when able. However, when it comes to 401(k) contributions, the decision to “Roth or not” isn’t quite as clear.

IRAs and 401(k)s (or other qualified retirement plan accounts) have different attributes and therefore require different considerations.

Roth vs. Traditional

Regardless of whether you are contributing to an IRA or a 401(k), it’s difficult to make a proper decision on contribution type without understanding the differences between traditional and Roth contributions.

Generally speaking, traditional retirement contributions will provide the account holder with a tax deduction in the current year, subject to certain income restrictions. Once in the account, the funds grow tax-deferred with income tax being owed on withdrawals in retirement.

Conversely, Roth contributions will not provide the contributor with a tax deduction in the year that the contribution is made. The tradeoff for the lack of deduction is that the funds grow tax-free and distributions in retirement can be taken without incurring tax liability. As you might imagine, this makes Roth retirement accounts very attractive to investors across the income spectrum.

401(k) vs. IRA

To add a layer of complexity, we need to also consider the account type to which the contribution is being made. 401(k) accounts and IRAs have a lot of similarities but also have some pretty big differences. The headline difference is that employer sponsored retirement accounts like 401(k)s and 403(b)s do not have the same income restrictions that IRAs have. Whether your earned income is $5 or $5 million, you can make pre-tax 401(k) contributions and deduct the amount contributed.

Many high earning households struggle with being able to build a Roth bucket of funds due to their ineligibility for making Roth IRA contributions. The lack of income limits for employer sponsored retirement accounts levels the playing field and allows some households access to the Roth tax treatment that they otherwise would miss out on.

So, it seems pretty clear, right? If I am ineligible for Roth IRA contributions, I’ll just leverage my 401(k) to build a Roth bucket. To quote the great Lee Corso, “not so fast my friends!”

Tax Tradeoffs in 401(k)s

As we’ve already established, there can be some powerful deductibility avenues available to individuals who make pre-tax retirement contributions. However, for high income earners, the ability to deduct IRA contributions is limited or simply not available. Additionally, certain other tax deductions and credits, such as the Child Tax Credit, Savers Credit, or American Opportunity Tax Credit, may not be available depending again on the level of their earned income. This makes the Roth vs. Traditional 401(k) contribution question that much more impactful.

At a certain level, outside of itemized deductions, the only other tax deduction available to a household with high earned income might be their pre-tax 401(k) contributions. Within an employer sponsored retirement plan, there are no earned income limits for deductibility, so it becomes crucial for high earning households to maximize what few deductions they have at their disposal.

For a household in the 22% or 24% tax brackets, they might be more comfortable biting the tax bullet and proceeding with Roth 401(k) contributions. Once you start to get into the 32%, 35%, and 37% tax brackets, it gets a little more difficult to voluntarily pass up one of the few tax deductions at your disposal. Ample consideration should be given to your anticipated future tax rates in retirement to determine whether the “juice is worth the squeeze”.

Your Retirement, Your Tax Strategy

At the end of the day, there isn’t a clear-cut strategy that will apply to every investor. Different people have different expectations of what the future will look like for them. It’s difficult enough to plan for 10, 20, or 30 years down the road. To make sure you feel empowered and enabled to make the proper election, work closely with your financial advisor and accountant to understand the pros and cons of each strategy both in the present day and for the future.

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