To Roth or not to Roth (401k)
We just finished tax preparation and filing. We now move into tax planning for the rest of the calendar year. The concept of a Roth retirement account continues to grow in popularity with the introduction of the Roth 401k and a plethora of articles about Roth IRA’s in general. Nearly 9 out of 10 employer plans now offer a Roth 401(k)*. Whether to contribute to a Roth is easily one of the most confusing questions facing our clients.
I’m currently in the work force and have a 401(k) at work. Should I contribute to the traditional 401(k) or a Roth 401(k)? As with so many financial planning questions, the answer is: It depends.
I’m going to start by mentioning one incontrovertible truth that confounds many people - if you contribute today to a Roth 401k rather than putting the same amount into a traditional 401k, your tax bill today WILL BE higher! Said another way, your paycheck will be smaller. How much more you pay today in taxes depends on your tax bracket.
In many ways, the philosophical answer of whether to contribute to a traditional or Roth 401k is simple - if your tax bracket today is the same as your tax bracket in retirement, it’s a complete wash. Yep, that’s right. If you are in the same tax bracket today as you will be in retirement, the final amount of spendable money is exactly the same. Let’s use an example: For this example, you are in the 22% tax bracket. Say you put $20,000 into your traditional, pre-tax 401k in 2024 and have 10 years to retirement. If instead you put $15,600 into your Roth 401k (remember, you would have 22% less to put in because you pay the tax up front). As soon as you retire, in year 11, you begin taking $10,000 spendable cash from the account. In 5 years, you will take out the exact same amount of cash and the money will be drained. Here is the comparison:
This is simply confirmation that if the tax bracket is the same during the contribution year(s) and withdrawal year(s), the account balances are exactly the same!
When does it make sense to contribute to a traditional 401k rather than Roth 401k? If you are in a higher tax bracket today than you expect to be in retirement, then you are better off in a traditional 401k. You save the tax today and agree to pay the tax when you pull the money out in retirement. Let’s say you are in the 35% tax bracket today and expect to be in the 22% tax bracket in retirement, you are better off putting your money into the traditional 401k.
Conversely, if you expect to be in a higher bracket in retirement, you are better off contributing to a Roth 401k. Why? You pay the taxes today at the lower rate. When you pull it out in retirement, you pay no tax at the higher rate.
How do you know your projected tax bracket comparison? That’s where planning comes in. Feel free to give us a call and we can set up time to do a tax planning session. As we always like to say, planning pays dividends.
Jared Kline, CFP, Enrolled IRS Agent
Planning Pays Dividends
513-768-2238 Cell
513-554-1472 Office
Brian Kellett, brian@kellettwealth.com. Phone 513-312-6067
Dave Bodnar, david@kellettwealth.com. Phone 513-258-6973
*9 out of 10 employers quote from CNBC article published 6/22/2023 titled “New to Investing? Run to this tax-advantaged retirement account, says CFP”
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