Traditional 401(k) or Roth 401(k)?

This is the million dollar question I get time and time again from friends and clients. I will start off by stating that I am not a tax professional and that this question, at its core, is a tax question. To my readers, it would be in your best interest to seek out the advice and counsel of your CPA to help you navigate this decision based on your personal financial situation. The purpose of this post is throw out some questions to consider when making Traditional vs. Roth decision.

The Basics

Before we dive in, it’s important to review the basics and differentiate between a Traditional 401(k) contribution and Roth 401(k) contribution. A Traditional 401(k) contribution is made with pre-tax dollars which means the contribution will decrease your taxable income in the year the contribution is made. The dollars within the Traditional 401(k) grow tax-differed until distributed, at your discretion, after your age 59.5.

A Roth 401(k) contribution is made with after-tax dollars which means that those dollars have already been taxed at your current marginal income tax rate. Once in the Roth 401(k), those dollars will continue to grow tax-free. Because those dollars were already taxed at the time of contribution, they will not be taxed at distribution.

They function in the same manner as a Traditional IRA and Roth IRA of which you can read in more detail in this post.

Within 401(k) plans, the account holder has the flexibility to contribute up to $19,500 per year ($26,000 if over age 50) into a 401(k) plan. If the 401(k) plan administrator offers a Roth 401(k) provision, which more and more plans are allowing, the account holder has even more flexibility to choose how those contributions are being allocated between the Traditional and Roth portion of the plan. For example, the employee could contribute solely to the Traditional 401(k), solely to the Roth 401(k) or a combination of the two. The million dollar question is what is the best combination?

The answer is, it depends.

Quiz Time

If you’ve read my other tax related posts, you’ve quickly realized that in order to answer a question I like to ask a few questions first. The answers to each question allows me to better understand the client and their current financial situation. Having a strong understanding of someone’s particular situation allows me to provide sound and relevant recommendations.

So on that note, class time to take out a piece a paper. We’re having a pop quiz!

1.Which statement best describes where you are in your career path?

A. Mid-career to late-career professional, close to reaching or already reached my peak income years.

B. Early-career professional still climbing the career ladder.

2. Which statement best describes your future income years?

A. I believe my income will remain the same or go down in the coming years.

B. I believe my income will go up in the coming years.

3. What do you expect your marginal income tax bracket to be in 2020?

A. 32% – 37%

B. 10% – 24%

4. I believe income taxes will go ______ in the future.

A. Down

B. Up or I don’t know.

5. I believe my tax bracket with go ______ in retirement.

A. Down

B. Up or I don’t know.

6. Which tax outcome would you prefer?

A. Reduction of taxable income.

B. Increasing the balance of a tax-free account.

The Results

So, how did you do?

Your responses to the quiz will dictate which type of 401(k) you should consider funding.

If You Answered Mostly A’s

If you found yourself answering mostly “A’s”, this tells me that you are a high income earner in your peak income years and expect to make the same amount or higher for the remainder of your career. Your answers also tell me that you believe that your taxes are at the highest levels of your lifetime and that you expect your income tax bracket to fall significantly during your retirement years.

If the paragraph above describes you, then you should consider focusing your 401(k) contributions into a Traditional 401(k). Based on your financial circumstances, you are likely getting “killed” on taxes and would greatly benefit from the tax deduction that comes with a Traditional 401(k) contribution. Additionally, if you believe your taxes are only going to go down in the future, then you would be better off avoiding today’s high tax rate and instead paying taxes at distribution when you expect to be in a lower income tax bracket.

If You Answered Mostly B’s

If you found yourself answering mostly “B’s”, this tells me that you are early in your career and expect your income to go up over time. You are likely years away from hitting your peak earnings ability which means your current tax rate is relatively low compared to your anticipated income tax rates in the future. Your answers also tell me that you expect income tax rates to go up over time (especially true given today’s low income tax rates due to Job and Tax Cuts Act of 2018) and that you would expect income taxes in retirement to be at a higher rate than your income rate today.

If the paragraph above describes you, then you should consider focusing your 401(k) contributions into the Roth portion of the plan. Based on your financial circumstances, you are early in your career trajectory. What you are earning today is low in comparison to what you expect to earn in the future. If this is the case, you would be much better off paying taxes on a contribution today, at a relatively low income tax rate, and have those dollars grow tax-free for the rest of your life. In this scenario, you would “win” this tax bet by paying a low tax rate today and avoiding a potentially higher tax rate in your retirement years.

Half & Half

If you found your “A’s” vs. “B’s” tally to be close, it was likely because of the last two questions on the future of your personal income tax rate and the overall direction of income taxes. Those questions were intentional to call out that we don’t know the future nor can we control where income taxes are going to go in the decades to come. That being said, if you don’t know with certainly where your tax rate will be in the future compared to now, why not put a little into both the Traditional and Roth 401(k)?

Personally, I am an advocate that everyone with access to a Roth 401(k) should be putting a portion of their 401(k) contributions into the Roth account. In this scenario, you can create a hedge (read buffer) in the event your retirement income taxes are higher or lower than your current income tax rate. Who doesn’t like a hedge!?

This is not advice and I am not telling you what to do. What I am trying to point out is the uncertainly of future tax rates and the opportunity everyone has today to make a bet on their current tax rate. There is an unknown chance that your tax rate at the time of distribution is going to be higher or lower than it is today so why not place your bet on both sides?

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