Soundtrack for this issue: “Invisible Touch” by Phil Collins
In 1986, Phil Collins sang, “She has a built-in ability to take everything she sees.” During tax season, I often think of those words, and if it weren’t for the title of the song, I’d say the lyrics are pretty accurate in describing how I feel when I look at my pay stub and what I paid in taxes. I have not met anyone who says that taxes have an “invisible touch” and would personally argue that the touch is quite apparent – and most certainly tangible. Taxes are a necessity, but that doesn’t make them enjoyable.
Tax management is an essential part of managing finances, so it is crucial to carefully choose between a Roth 401(k) or a traditional 401(k). Despite taxes driving much of the decision between different retirement accounts, there are other factors to consider, too. This month, I want to discuss what I believe to be the benefits of a Roth 401(k) versus a traditional 401(k).
1. Taxes: Before we look at the benefits of each, let us revisit how these two retirement accounts work. With a Roth 401(k), you pay taxes today, leaving the account to grow tax-free, which means that the money you take out later from that account is tax-free. With a traditional 401(k), you put in money that has not been taxed, leaving it to grow tax-free, but then pay income tax on what you take out. If the tax rate is the same in the future as it is today, you will end up with the same amount of money whichever account you choose. In the following example, the time period is 10 years, the account doubles from growth, and the tax rate is 20% for both periods.
Roth: Make $10,000 and pay 20% tax. You now have $8,000 to contribute. Double the account over 10 years, and you have $16,000.
Traditional: Make $10,000 and can contribute $10,000. The account doubles over the 10 years to $20,000. To take it out, you pay 20% income tax, which leaves you with $16,000.
With taxes being the main factor in the decision-making, the question you may ask yourself is, “will taxes be higher in the future than they are today?” That is only a part of the equation, though. In reality, the question is twofold: will all tax brackets be higher in the future than today, and which tax bracket will you be in today versus in the future. Neither I nor anyone else can with any certainty answer the first question. If I had to guess, though, I’d opt for higher taxes in the future. My reasoning primarily is focused on the recent gigantic stimulus packages, which at some point will require repayment. I also base this on what seems to be a general movement of our society pushing for free healthcare and education that would require higher taxes. But this is as much an opinion as it is a guess.
2. What are the benefits of the Roth 401(k)? I like a Roth 401(k) for max contributions, planning purposes, and passing on assets. An individual can contribute a combined amount of $19,500 to their traditional and Roth 401(k) in 2021. If you max out your 401(k), you will get more after-tax dollars via a Roth 401(k) than you would with a traditional 401(k). Let’s use an example: if you put in $19,500 in a Roth 401(k), you have already paid taxes. Put the same money into a traditional 401(k), and you must pay taxes and therefore don’t have as many after-tax dollars in the account. This leads to the planning aspect of a Roth 401(k). If you have $1 million in a Roth 401(k), you have $1 million. If you have $1 million in a traditional 401(k), you still have to pay taxes on the money and may only have $800,000 after an assumed 20% tax rate.
Finally, the Roth 401(k) may be the best option for passing money on to beneficiaries in the future. Right now, if you inherit a 401(k) from a parent, you must take all the money out within ten years due to the SECURE Act. Statistically, most beneficiaries will inherit their parents’ 401(k) at the peak of their career, which means they pay the highest amount of taxes and will have to pay those taxes on the inherited IRA distributions. If you inherit a Roth 401(k), you must still withdraw the money within ten years, but you will generally not have to pay taxes. A no-tax kind of gift climbs high up on my wish list.
3. What are the benefits of a traditional 401(k)? To me, the most significant advantage of a traditional 401(k) is flexibility. With a Roth, you must pay taxes the month you contribute, which does not allow for much flexibility or planning. With a traditional 401(k), you get more control over when you pay the taxes. With the SECURE Act, the age you must take your required minimum distributions is now 72. Besides your required minimum distributions, though, you have control over things. You can choose when to take more money out or to do a Roth conversion on lower-income years. Additionally, if you do not need your 401(k), you can make Qualified Charitable Distribution (QCD), which allows you to donate away a portion of your 401(k) each year and not have to pay taxes. There is more to dive into with the flexibility options but suffice to say, there is flexibility with realizing taxes with a traditional 401(k), which you do not get with a Roth 401(k).
4. Should I fully commit to one or the other? This is a great question. Everyone’s financial situation is unique, which is why it is best to consult an advisor or accountant on what option works best for you. If you want to play it safe and not put all your eggs in one basket by choosing one over the other, you can always do a 50-50 split. Doing a split like this means that you would contribute half to a traditional 401(k) and half to a Roth 401(k). We never know what legislative changes could bring to either a traditional or Roth 401(k) in the future. Choosing to split your retirement savings down the middle may provide you a more cautious approach and a sense of security, knowing you are not fully committed to one over the other.
It is important to consider these factors when deciding which 401(k) vehicle to use. Even though I wrote about 401(k) here, the same applies to IRAs. The max contribution limit is lower for an IRA, but each vehicle’s underlying benefits still apply.
Fortunately, when you optimize between retirement accounts, taxes won’t feel entirely like the “invisible touch” Phil Collins sang about, as you now have the information to make an informed decision. However, they may still be “something you just can’t trust, something mysterious.” Even if taxes are the most widely considered factor in the Roth vs. traditional equation, there are also other aspects to consider when deciding which option is best for you and your financial well-being. The government needs its share to keep things running, and you can count on it getting the money at some point. The questions to ponder are whether you want to pay taxes today or in the future and what your and your advisor’s best guesses are on what those taxes will be, now versus later.