Frequent questions from 401k plan participants focus on the type of contributions they should make; either Roth 401k contributions or traditional pre-tax 401k contributions.
The results of new a study confirm my answer—making Roth 401k contributions appears to be better for everyone.
How Roth 401k and pre-tax 401k contributions differ
Traditional pre-tax 401k contributions are made without deductions for state and federal taxes. Contributions and earnings grow tax-free until they are withdrawn. At distribution, contributions and earnings are taxed at the individual’s state and federal tax rates.
Roth 401k contributions are after-tax contributions. They also grow tax-free (along with the associated earnings) until withdrawn. Different from pre-tax 401k contributions, Roth 401k contributions and earnings are not taxed when withdrawn, provided they have been in the plan for at least five years and are paid out due to a distributable event.
The old way of determining how to contribute
Until I reviewed the results of the study, my answer would have been to make both traditional pre-tax 401k contributions and Roth 401k contributions. Here’s how I came to that conclusion:
If you believe that tax rates will be higher in the future (and most tax experts do), it would be best to have your contributions taxed now at a lower rate rather than in the future at a higher rate when your balances are distributed. This line of thinking favors making all Roth 401k contributions.
However, the future is uncertain.
Although we are close to historically low tax rates at both the state and federal levels, there is no guarantee that tax rates will be higher in the future (even though the odds seem to favor it).
As a result, it appeared to make sense for 401k plan participants to make both Roth 401k and traditional pre-tax 401k contributions in whatever percentages they felt most comfortable (e.g., 5 percent Roth plus 5 percent traditional 401k or 7 percent Roth + 3 percent traditional 401k).
This strategy seemed to ensure that whatever happened with tax rates in the future, participants would benefit with at least a portion of their total 401k account balance.
Results of new study
The study, produced by researchers at the Harvard Business School, looked at Roth 401k accounts. What they found is important in determining a contribution strategy for participants with the option of making both Roth 401k and traditional pre-tax 401k contributions.
A key finding was that participants contributed the same percentage, amount whether they made Roth 401k contributions or traditional pre-tax 401k contributions. This is important because, in the case of Roth 401k contributions, taxes have already been paid. An example may help.
Assume one participant makes 10 percent traditional pre-tax contributions and another makes 10 percent Roth 401k contributions for their entire careers. Also, assume that they invest in the same funds and have the same earnings experience. Let’s say they both end up with $1 million at retirement.
The Roth 401k plan participant truly has $1 million, however, the traditional 401k plan participant has $1 million minus state and federal taxes. A huge difference.
The study notes that a way for traditional pre-tax 401k participants to make up the difference would be for them to save some of the tax savings each year into an account that would be used to pay taxes when balances are distributed. But no one does that, it’s just not how we think.
The Roth promise
Given these study results, it will still be difficult for many participants to make contributions exclusively to Roths, because they don’t believe the government will maintain the 100 percent tax-free withdrawal provision associated with Roth 401k balances.
In other words, they don’t expect our elected officials to keep their Roth promise.
I believe that if there is a change in the tax code regarding Roth 401k account withdrawals, it is likely that grandfathering provisions will be attached, so building a Roth 401k account balance is probably worth the risk.
If you don’t currently offer Roth 401k accounts in a sponsor’s 401k plan, you should consider adding them, and in-plan Roth 401k account conversions as well. All plan sponsors should consider emphasizing in their education sessions the significant benefits of contributing to Roth 401k accounts.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Lawton is an award-winning 401k investment adviser with over 30 years of experience. Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to 401k plan sponsors. For more information, please contact Robert C. Lawton at (414) 828-4015 or [email protected] or visit the firm’s website athttp://www.lawtonrpc.com.