I received a reader question over the weekend from Ezekiel. Ezekiel gets an employer match for the first 6% he sends to a 401(k) and he asks whether it made sense for him, as someone making six figures who plans to work until 65, to contribute to a Roth 401(k) instead of a traditional 401(k).
First a definition.
What is a Roth 401(k)?
A Roth 401(k) is a separate account in the 401(k) your company holds for you that holds designated Roth contributions — that is, contributions that you’ve paid taxes on now and that won’t be treated as taxable income in retirement.
For the 2014 tax year, the sum of your total contributions to a traditional 401(k) and a Roth 401(k) may not exceed $17,500, or $23,000 if you’re over 50.
Difference from a traditional 401(k)
The primary difference is that contributions made to a Roth 401(k) are made with after-tax dollars, and that distributions are not taxed if taken after you reach 59 1/2.
Difference from a Roth IRA
The most obvious difference is that Roth 401(k) contributions are made into an account set up by your employer and Roth IRA contributions are made into an individual account. As such, the two are subject to different limits. In other words, if eligible, you may contribute $17,500 to a Roth 401(k) and $5,500 to a Roth IRA for the 2014 tax year.
You do have to take required minimum distributions from a Roth 401(k) account by age 70 1/2. This isn’t the case with a Roth IRA
However, the main difference for Ezekiel is that there is no income limit to participate in the Roth 401(k). A single person with a modified AGI over $129,000 or a married couple filing jointly with a modified AGI over $191,000 may not contribute to a Roth IRA.
Ezekiel isn’t quite at the Roth IRA’s limits yet, but he’s likely to get there pretty soon.
Advantages of the Roth 401(k) for high earners
Because the main difference between the Roth and traditional 401(k) boils down to whether you’d rather pay taxes on the money now or in retirement, the starting point for the decision depends on where you expect your tax rate — and to some extent ALL tax rates — to be when you retire.
If you plan to take less out of your accounts each year after you retire than you’re currently making in income, you’ll generally see a lower marginal tax rate while in retirement and should thus tend toward the traditional 401(k)
That said, there are a few compelling reasons to have some money in Roth accounts:
Taking a distribution before retirement
He definitely should plan to not have to take distributions from his retirement savings before he retires, but if some emergency pops up, he’ll be able to withdraw money from the basis he put in — but not the earnings — from a Roth 401(k) account without penalty. He would have to pay a penalty on any money taken from a traditional 401(k).
Taking a lump sum distribution in retirement.
While the average amount Ezekiel takes out each year in retirement may be lower than his current income, there may be some years where he takes out a much higher amount — perhaps when he decides to pay cash for a sailboat that he uses to invite me on trips. Taking a big distribution like this from a traditional 401(k) might bump his Adjusted Gross Income up into a higher marginal tax bracket — not so with money pulled from a Roth 401(k).
Taxable income management
I just mentioned that distributions from a Roth 401(k) don’t add to your AGI for tax purposes, but the IRS isn’t the only federal office that cares about your adjusted gross income in retirement. Your medicare premium and the amount of your Social Security payments that are subject to taxes also depend on your AGI. I suspect that by that point, Ezekiel will have plenty of tax shelters to manage his AGI, but it’s still something to consider.
So how much?
Alright, so if the conclusion is that:
- he should shoot to have most of his money in traditional 401(k) accounts to take advantage of deferring taxes until he’s in a lower marginal bracket, but
- there are real reasons why he’d benefit from having some of his money in a Roth 401(k)
then how should he decide how much to put into each?
To figure that out, he would have to create projections based on his expectations for income growth, inflation, future tax rates, growth of his invested portfolio, and idiosyncrasies of the sailboat market.