An election – putting a mark beside either a standard a 401(k) retirement contribution plan and its lesser-known Roth IRA option – will for many Americans determine to a great degree their retirement income stream and the effect on their taxes.
Often, people making this choice don’t fully know the qualifications of each retirement plan option – or even that a choice exists. Down the road, this can result in people realizing they chose the one less advantageous for their needs.
The alternatives in this election are:
- A traditional employee pre-tax contribution
- The lesser-chosen Roth after-tax contribution
The decision in one sense is pretty straightforward: get a tax benefit now because the employee’s contribution is tax deductible, or choose the Roth option. With the Roth, taxes are assessed as funds are contributed – but on the back end, the withdrawals are untaxed.
For example, a taxpayer in the 25% tax bracket who puts $10,000 into the traditional 401(k) plan reduces their taxes by $2,500. When they withdraw those funds at retirement, they’re taxed on their’ tax bracket at that time. In that sense, they’re taxed on the money they contributed as well as the growth.
Under the Roth option, the tax advantage comes when withdrawals are made. Taxes are paid on the contributed amounts – but it’s tax-free when withdrawn. Therefore, the growth over the years – however much that growth might be – is untaxed. The IRS takes a “pay me now or pay me later” approach: Either way, it’s going to get its money. The questions are when, and how much, and which allows you to pay less, or get a better return?
There’ no one-plan-fits-all in retirement planning. Taxpayers, tax situations, retirement needs, short-term tax advantages vs. long-term tax benefits are different for different people. For younger taxpayers, the Roth option has greater advantages because they have more years to contribute and for their investment to grow “tax free.” Nevertheless, under certain conditions, the Roth Option is worth consideration for those nearing retirement. For some, the retirement date isn’t the important thing. Some people have additional savings along with their retirement-dedicated funds. In those cases, many choose to spend Roth money last rather than first, sometimes years after retirement.
Generally speaking (but with myriad of scenarios based upon individual circumstances, risk tolerances, targeted returns, etc.), the Roth option may better serve those who plan to wait at least eight years before distributing funds. This isn’t a hard-and-fast figure; rather, it’s a question that should be answered in consultation with one’s investment advisor. The longer the timeframe, the greater the untaxable growth on your retirement money.
Choosing the Roth option means financial ground will have to be made up as opposed to the traditional pre-tax contribution. The Roth offers no initial tax advantage. It’s playing catch-up against the traditional plan. The break-even point – again, generally – is about eight years. Higher rates of return mean faster catch-up and greater growth from that point.
Employer-matching or profit-sharing contributions aren’t part of the employee’s Roth plan. There isn’t a related up-front tax consequences for employer funds contributed into your 401(k); however, you’ll be taxed on it upon withdrawal from the plan.
It’s likely your employer’s plan provides the Roth after-tax contribution option. Such plans providing this option are widely used by most employers.
What often seems to happen in 401(k) plan elections is that employees choose the traditional pre-tax option because it seems the easiest, the Roth isn’t explained, or because they’ve always done it that way. But it may not be the right way.
Research your options. It’s your election – and you’re the only one voting.
This article first appeared in KnoxNews.