To Roth or Not to Roth

To Roth or Not to Roth

The benefits of a Roth 401(k)

Working in the San Francisco Bay Area, we often visit growing tech firms to advise employees on how to manage their money. While many of these professionals are brilliant at what they do, they quickly recognize that their substantial compensation packages can be quite complicated, and they welcome expert advice on a variety of financial topics.

We’re struck by how often certain questions come up. And here’s a good one:

“I don’t really get the difference between a Roth and non-Roth.
Which type of 401(k) account is best to save for my retirement?”

Roth 401(k)s are relatively new in the tax-advantaged retirement savings realm. They were created in 2006, and not all employers that offer a traditional 401(k) provide a Roth option as well. Yet, if available, employees with a higher income have a better way to save for retirement and save taxes.

What is a Roth 401(k)?

First, a Roth 401(k) is similar to a traditional pre-tax 401(k) that may be offered through your employer. Contributions are taken regularly from your paycheck, and you can determine the amount, up to the annual limit. For 2019, you can contribute up to $19,000, or $25,000 if you’re 50 or older. You have the flexibility to contribute to either type of 401(k) at the same time, but the annual limit applies to the total of both your Roth and traditional 401(k) contributions.

Yet, like a Roth IRA, contributions to a Roth 401(k) are made after tax. While you’ll pay taxes on your income today, the benefit is the investment earnings on your contributions will be tax-free at age 59½, as long as you have held the account for five years.

One key advantage of a Roth 401(k) over a Roth IRA is no income limits. You can’t contribute to a Roth IRA if your modified adjusted gross income in 2019 is $203,000 or more for married couples or $137,000 or more for single filers. Consequently, a Roth 401(k) becomes a great option for people who earn higher salaries.

Some employers will also match all or part of your 401(k) contributions, adding to your retirement account. However, keep in mind that if your employer offers a match, the employer’s share must be put in a traditional 401(k). So in this situation, you will get the best of both worlds if you choose to allocate your contribution to a Roth 401(k).

Key characteristics of Roth 401(k)s vs Traditional 401(k)s

Roth 401(k)Traditional 401(k)
Contribution limits for 2019$19,000$19,000
Catch-up if 50 or olderAdditional $6,000Additional $6,000
ContributionsDeducted from paycheck after-taxDeducted from paycheck pre-tax
Withdrawals on qualified distributionsTax-freeTaxed as ordinary income
Qualified distributions59½ or older
Account active for at least five years
59½ or older
Required Minimum Distributions at 70½No — if still working (unless 5% owner)
Yes — if not rolled over into a Roth IRA beforehand
No — if still working (unless 5% owner)
Yes — whether it is rolled over into an IRA or still in a 401(k)

Is a Roth 401(k) right for me?

Both pre-tax and after-tax 401(k) accounts are great options to save taxes and build savings for retirement. The question is which strategy is best for you, given your assets, earnings and retirement horizon. Here are a few things to consider when deciding whether to go Roth or not:

1. What is your projected income when you retire?
If you expect your retirement income to be more than what you earn today, then a Roth may be better. The distributions you take from your Roth 401(k) will be tax-free income.

Note that whether from a traditional or Roth, you will be required to take minimum distributions at age 70½ or when you retire, whichever comes later, unless you own 5% or more of the employing company. Then you must take distributions at 70½, even if you are still employed. Minimum distributions are calculated based upon the balance of your account and your life expectancy.

Consider all the income streams you will have during retirement, such as Social Security, pension payments and trust distributions, in addition to required minimum 401(k) distributions. These 401(k) distributions can quickly increase your gross income, pushing you into a higher tax bracket and impacting the amount you pay in taxes on your Social Security income and Medicare premiums. Contributing to a Roth 401(k) and rolling it over to a Roth IRA before you reach 70½, allows you to reduce future income from required minimum distributions.

A great strategy to avoid taking required minimum distributions from your Roth 401(k) is to roll funds over into a Roth IRA once you retire. Unlike Roth 401(k)s, Roth IRAs are not subject to required minimum distributions.

2. What are your current cash flow needs?
Keep in mind when electing to contribute to a Roth 401(k) versus traditional 401(k), the net income you take home per paycheck will be reduced. The tax withholdings will be higher with a Roth 401(k) because you’re paying taxes now on contributions. Be sure you’re bringing home enough to meet current expenses and short-term financial goals.

3. When do you expect to retire?
If you’re younger, chances are your salary is much less that what it could be 20 or 30 years from now, so the tax savings from a pre-tax 401(k) is limited. Meanwhile, the amount of earnings over that period in your 401(k) could be substantial, so a Roth would be a better option.

On the other hand, if you plan to use your retirement savings sooner, within 10 years, then you may want to take the tax savings today with a traditional 401(k).

Run the scenarios

Generally, we recommend putting more money into a Roth 401(k) when you are starting your career, which allows for tax-free distributions in retirement. As you age and your income grows, saving in a traditional 401(k) may be better.

For instance, we recently met with an employee at a Fortune 50 tech company who graduated from college three years ago. We recommended to her that she put all her retirement savings into a Roth 401(k). As her income grows, we can re-evaluate how she should allocate between a traditional pre-tax 401(k) and a Roth 401(k).

We also spoke to an employee who recently experienced a seven-figure liquidity event when the company where she worked was acquired. She’s aiming to retire in about 10 years. In this case, we recommended she fully fund her traditional 401(k) for the year, knowing that her taxes from both ordinary income and capital gains will be high.

A Roth 401(k) provides great flexibility and, depending on other special circumstances, could be an attractive option. Because of the various factors to consider, you should review whether “to Roth or not to Roth” with a wealth manager or a CPA. Your financial advisor should be able to run through various scenarios to estimate your projected income, apply current tax laws, and plan so that your cash-flow needs are met for today and tomorrow.