It’s a question of when you pay your taxes
Often in 401(k) enrollment meetings with employees of equipment dealerships we are asked about the differences between Traditional and Roth deferrals. First, it is important to remember that employer contributions always will be taxable.
The basic difference between employee contributions being designated as Traditional or Roth is when you pay the taxes. That said, we are often asked the question of which investment platform is most advantageous in terms of how much money a participant will have at retirement age.
In a Traditional 401(k) you contribute pre-tax dollars that are deductible from your current income and lower your current tax bill. Your money, both contributions and earnings grow “tax-deferred” until you withdraw them, hopefully after age 59½. At that time, withdrawals are treated as ordinary income and you pay taxes based on your current income tax rate.
The Roth 401(k) is pretty much the reverse. You make your contributions with after tax dollars, meaning you pay the tax now and there is no upfront tax deduction. However, in the future, withdrawals of both contributions and earnings are “tax free” at age 59½, as long as you’ve held the account for five years.
So we sit here and weigh two questions: pay the taxes now (Roth) or pay the taxes later (Traditional)?
Some economists have made a convincing argument that future tax rates will need to double in order for the country to afford the obligations it has made, primarily for Social Security, Medicare and Medicaid. Could tax rates really double? These same economists have made the argument that, yes, they could; and that today, we live in an era of historically low tax rates. After all, in 1943 the highest marginal tax rate was 94 percent of any income over $200,000.
On the other side of this debate, our current political leaders are advocating for the reduction of current income taxes on the middle class. Where does this leave us in the future in terms of tax rates? The answer is that no one really knows what Congress will do, if anything, to the existing rates.
The bottom line
Therefore, the bottom line really comes down to future tax rates. If you think tax rates will be higher than they are today in the future, a participant is likely better off paying the taxes now while they are low by participating in the Roth platform. If you think tax rates will be lower than they are today, it is a better plan to pay the lower taxes in the future by participating in a Traditional 401(k). If tax rates stay the same, they are probably both about equal in terms of how much money a participant will have in their hands at retirement.
There’s a lot to consider when determining if Roth contributions may be right in your situation. You may welcome the advice of a trusted financial professional as you assess this option in relation to your overall financial goals for retirement.
Here are some similarities and differences between a Roth 401 (k) and Traditional 401(k):
|Item||Roth 401(k)||Traditional 401(k)|
|Contributions into account||After tax||Before tax|
|Retirement distributions taken from account||
Free from federal tax if occurs 5 tax years after 1st Roth contribution AND after participant either: Reaches age 59-1/2; Dies; or Becomes disabled
|Taxed as ordinary income in the year taken|
|Required Minimum Distributions (RMDs)||Required. However, a Roth 401(k) can be rolled over to a Roth IRA prior to RMD to eliminate this requirement||Required|
|Level of income limits participation||No||No|
$18,000 limit in 2017
|$18,000 Limit in 2017
$6,000 additional contributions allowed if over age 50
Article Written By David Wentz
David Wentz is CEO of Tax Favored Benefits, Overland Park, Kansas. Wentz is a graduate of the University of Kansas School of Law with a Juris Doctor degree. Wentz frequently speaks at various professional and business seminars about pensions, profit sharing, 401(k) plans, tax favored benefits, and investment programs. Western Equipment Dealers Association endorses Tax Favored Benefits as a 401(k) provider. No compensation is received. More information is available at www.taxfavoredbenefits.com.
Securities and investment advisory services offered solely through Ameritas Investment Corp. (AIC), Member FINRA/SIPC. AIC and Tax Favored Benefits, Inc. are not affiliated. Additional products and services may be available through David B. Wentz or Tax Favored Benefits, Inc. that are not offered through AIC. Securities email: email@example.com