This overlooked option can help you hedge against future tax changes
By Penelope Wang (Consumer Reports)
In the 13 years since Roth 401(k)s were first launched, these accounts have become a standard option in most retirement plans. Seven out of 10 of employers now offer a Roth 401(k), according to a soon-to-be released survey by Vanguard.
Yet so far, workers have largely ignored their Roth accounts. Last year, only 11 percent used a Roth 401(k) in plans where one is offered, down from 13 percent in 2016, Vanguard data show.
That’s a missed opportunity. Roth 401(k)s offer one of the best options for building a tax-free stash of savings.
Contributions to these accounts are made with after-tax dollars; those to traditional 401(k)s are made with pretax dollars. You can contribute to both 401(k)s at the same time, but the combined amount can’t exceed the current limits of $19,000 per year for 2019 ($26,000 if you’re 50 or older).
Roth (401)k plans, like traditional 401(k) plans, have no income limits for contributions. They also are eligible for your employer match, which is typically 50 cents for each dollar you contribute up to 6 percent of salary.
Don’t confuse a Roth (401)k with a Roth IRA. Though both are funded with after-tax dollars, Roth IRA contributions are limited to $6,000 per year ($7,000 for those 50 and up). Roth IRA contributions also begin to phase out for single filers earning $122,000 or more in 2019 ($193,000 or more for those married filing jointly).
Why aren’t more people choosing a Roth 401(k)? For starters, many people are confused by the tax rules, as a 2015 Harvard study found. Inertia and lack of awareness about the Roth are also factors.
“Most workers are auto-enrolled into pretax accounts, or they signed up years ago, so they may not have looked at their plans since then,” says Jamie Hopkins, director of retirement research at Carson Group, an investment management firm based in Omaha, Neb. “And many people prefer to have an immediate tax deduction.”
It’s time to take another look at your plan. A Roth 401(k) can be a great deal, especially for younger workers with low incomes, because they are likely to be in a higher tax bracket at retirement. But a Roth 401(k) is a valuable option for retirement savers of all ages and income levels. Here are three key reasons to consider one:
1. Your Savings Will Be Worth More in Retirement
When you make a contribution to a pretax 401(k) account, your taxable income is lowered by the amount you put away. That gives you an immediate tax break, and your money grows tax-deferred. But when you eventually make withdrawals, you will pay taxes on the amounts you take out, which will reduce your retirement income.
By contrast, you put after-tax dollars in a Roth 401(k), so the growth and withdrawals are tax-free. That means you have the full balance of the account available to spend in retirement.
“It’s harder to fully fund a Roth account, since you have to pay taxes first, but there’s a bigger reward at the end,” says William Bernstein, an investment adviser and author of “The Four Pillars of Investing” (McGraw-Hill, 2002).
2. You Are Likely to Save More
“The switch to a Roth is tied to getting more serious about saving,” says Rob Austin, director of research at Alight Solutions. Workers who contributed to a Roth 401(k) saved 10.1 percent of pay on average, which is almost 2.5 percentage points more than the average 401(k) saver, according to recent Alight data.
Alight also analyzed the data from 25,000 employees who switched to a Roth from a pretax account in 2018. More than two-thirds of those in this group raised their contribution rate from an average 7.1 percent of pay to 11.7 percent.
The survey did not ask workers why they increased their contributions. But the decision to move to a Roth may have spurred employees to improve their overall retirement plan, including hiking their savings rate, Austin says.
3. You Benefit From Tax Diversification
For many savers, using a Roth seems dicey. You’re giving up a tax break today for future tax-free withdrawals, but you don’t know whether you’ll come out ahead because you can’t predict your tax bracket in retirement.
But there’s a simple workaround: Split your 401(k) contributions between your Roth and pretax accounts. “By holding both pretax and after-tax savings, you have the advantage of tax diversification,” says Mike Piper, a certified public accountant who runs Oblivious Investor. “That way, you are hedging your bets if you guess wrong about your future tax rate.”
The amounts you put in your pretax and Roth accounts should be geared to your financial goals and overall portfolio. If you’re just starting out, you might consider funneling the bulk of your savings into a Roth because you are more likely to end up in a higher tax bracket than you are now, Piper says. You will still have tax diversification because employer matches are made with pretax dollars.
Midcareer investors might stash 60 percent of their 401(k) savings in a pretax account and the rest in a Roth. Because you will give up some of your pretax money to taxes, your retirement portfolio will be more or less evenly divided, in spending terms, between pre- and after-tax savings.
At retirement, you can roll your Roth 401(k) over into a Roth IRA, which means those funds are no longer counted in determininghow much you must take starting at age 70½. Those distributions might otherwise push you into a higher tax bracket, and it leaves you more flexibility in retirement.
And the ability to tap tax-free savings can also help retirees avoid triggering taxes on other benefits, such as Social Security income or healthcare subsidies for those not yet receiving Medicare, Piper says.