Should my 401(k) contributions be Traditional or Roth?
Text from the Revenue Act of 1978, which created the 401(k) we know and love.
Tom is 58 years old. For the first half of his working career, he diligently saved into a Traditional (pre-tax) 401(k) with his employer. Five years ago, his employer began offering a Roth 401(k), and since then he has been putting all his retirement savings into that account.
Now, Tom is thinking about retirement and wants to make sure he is doing the right things to prepare himself. One of his questions is whether to continue saving in the Roth or to go back to the Traditional account (or maybe a blend of the two?)
The “Roth vs Traditional” debate is one of the most written-about topics in personal finance, and for good reason. It has all the hallmarks of a Hollywood movie: the excitement (tax-free income!), the uncertainty (what will my tax rate be in retirement?), the drama (what if Congress starts taxing my Roth accounts?).
Most financial advisors will use some sort of software to project your future income and give you a good idea what is the right decision for you. In this article I will explain how you can think about this decision without doing all the projections and mathematical calculations.
Death and taxes
Whenever you receive income from your job, you must include the amount in your taxable income and, generally, pay taxes on it. No exceptions, right?
If you are 50 years or older, you can contribute $30,500 into your 401(k) in 2024. Under 50? The limit is $23,500
The IRS allows employers to set up a 401(k) plan, by which you can withhold a certain amount of your income into a separate account and defer the taxes. When you reach age 59 ½, or when you leave your job after age 55, you can withdraw money from this account, and you must include the withdrawal in your taxable income. This, arrangement, known as the Traditional 401(k), works well if your tax rate is higher while working than when you withdraw the money. A traditional IRA uses the same tax-deferral concept, though the rules are much different (consult an expert).
Not every employer offers a Roth 401(k). A Roth IRA is available to all individuals, but is subject to limitations for high-income individuals.
The Roth 401(k) is inverse of the Traditional 401(k). A Roth account does not offer a current-year tax deduction but allows you to withdraw money tax-free after age 59 ½. This works well if you have a lower tax rate now than in retirement.
This raises the question of “what will my tax rate be in retirement?” Using financial planning software, financial advisors can project your future income and tax rates to make a decision based on data.
Without the projections, you can use some guidelines and rules of thumb to make your decision. The most important concepts I use are diversity of income sources and current vs future income.
Diversify your income sources
For many people, income in retirement comes from four sources. I’ll list them below, with a quick note of how they fit into the planning process:
Most 401(k) plans allow you to split your contributions between Traditional and Roth.
Because each of these income sources have different taxation structures, having a blend of each source gives you flexibility when creating your retirement spending plan. And since the rules of taxation are always changing, I believe it’s a prudent strategy to have a little bit in each bucket.
Consider your current and future income
Another thing to consider is your current income, relative to either your typical income or to your retirement income.
Situations where Traditional may make sense:
If you are in a commission-based business and just had one of your best – and highest-income – years, it may be a good idea to use the Traditional 401(k) and avoid paying taxes in the higher tax brackets.
If you plan to retire before age 70, you may want to consider Traditional contributions paired with a Roth conversion strategy in the low-income years prior to collecting social security benefits. If you do this, it’s a good idea to invest your current-year tax savings in a taxable account to pay the taxes on the future Roth conversions.
Situations where Roth may make sense:
Conversely, if you have already begun winding down your career and are working less hours or maybe a different, lower-paying job, you may want to consider Roth contributions, as your income may increase in retirement due to Social Security benefits and required minimum distributions.
If you will have pension income in retirement, either through government employment or another union job, you may want to consider Roth contributions, as your pension plus Social Security will create a high level of taxable income that you won’t be able to control.
Are you a giver? There is a safety valve
The biggest problem with over-saving in Traditional (pre-tax) accounts is when your Required Minimum Distributions (RMD) begin. At age 73 (age 75 if you’re born in or after 1960), the IRS requires you to withdraw (and include in taxable income) a certain percentage of your pre-tax accounts. These RMDs can cause a large spike in income taxes, which is a problem, especially if you don’t need the income. Fortunately, there is a way to avoid this.
You cannot make a QCD from a 401(k); you must first rollover your 401(k) into an IRA.
Beginning at age 70 ½, you can make tax-free withdrawals (called a Qualified Charitable Distribution or QCD) from your Traditional IRA to a qualified charity, including a church. This withdrawal will satisfy your RMD requirement without incurring income taxes. In 2024, you can do a QCD of up to $105,000, which is higher than RMD for most people.
Summary
The decision of whether to use your Traditional or Roth 401(k) can be a stressful one. Much of the stress comes from the uncertainty of the future. By adhering to the principle of income source diversification, making educated guesses on your current vs future income, and keeping in mind the tax-free charitable distribution, you should have a little more clarity on the decision. And since most plans allow you to do a combination of Traditional and Roth contributions, you can hedge your bet on future tax rates.
“The most important thing is the one thing you can control: your behavior.”
Remember, personal finance is highly personal, and although I have shown some rules of thumb, it’s always a good idea to seek professional advice. Most financial advisors will give you a free consultation, and even if they can’t directly answer your question without a formal engagement, they should be able to educate you during your consultation.
Finally, I always tell clients the most important thing is the one thing you can control: your behavior. By choosing to save (regardless of which account you save in) you are putting yourself in a good position to have a successful retirement. The Roth vs traditional is an important decision, to be sure. But it doesn’t matter a lick if you aren’t choosing to save.
(Oh, and to pay off my comment on Congress from earlier: the experts I trust believe Roth accounts will not be taxed in the future, for two reasons.
One: Congress likes Roth accounts. Congress is short-sighted and sets their budgets only ten years in the future, meaning it’s better in their eyes to take their tax revenue now than to defer to the future.
Two: Too many stakeholders have interests in Roth accounts, from consumers like you and me to the giant financial institutions. If they tried to take away the benefits, there would be a lobbying frenzy.)
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