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Know Your Options

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Know Your Options

If your plan offers a Roth 401(k) provision, your participants might ask, “Which one is better for me?” As the availability of Roth options in 401(k) plans and Roth contribution percentages continue to rise, it’s important to be able to guide participants in making the right choice.

401(k) plans offer many advantages to participants; the ability for accounts to grow on a tax-deferred basis, the chance of receiving employer contributions in the form of a match or non-elective contribution, the ability to contribute even after attaining age 70 ½, and protections from bankruptcy. These benefits are consistent whether a participant chooses traditional or Roth contributions, or even both! So, what makes Roth and traditional routes different and what are the advantages and disadvantages of each?

Traditional 401(k) contributions, or those contributed on a pre-tax basis, have been the mainstay of the 401(k) plan since its inception in 1978. Today, more than 50 million workers are active participants in their employer’s 401(k) plan and, until 2001, all contributed on a pre-tax basis. Pre-tax contributions are deducted from an employee’s paycheck before the application of federal and state income taxes. (Pennsylvania is the only state that does not exempt 401(k) contributions from personal income tax.) These contributions, along with any employer contributions and investment gains, remain tax-deferred until withdrawal. At the time of withdrawal, the participant will pay all appropriate income taxes due. If withdrawals occur before age 59 ½, disability, or death, an additional early withdrawal penalty of 10% will apply.

On the contrary, Roth deferrals are contributed on an after-tax basis with the employee paying all current federal and state taxes. Once contributed to, these accounts accumulate in the same fashion as traditional 401(k) accounts until withdrawal. With a Roth account, your contributions and their investment earnings can be withdrawn tax-free, provided the withdrawal does not occur before age 59 ½, disability, or death. Even with an early withdrawal, only the investment gains and employer contributions will be taxed as income and subject to the 10% penalty.

What is the attraction of utilizing Roth 401(k)? It’s down to the individual participant’s tax situation. For young employees, who’s income and tax rates are low, paying the tax now makes sense. Chances are, their tax rates will be higher in the future. For those with many years to retirement, the compounding of their investment gains will make up a far greater percentage of their account than their contributions. Being able to withdraw those funds tax-free can be very attractive. For participants who are paying a high tax rate currently and might be closer to retirement, Roth may not be so attractive. One exception might be if the participant plans to leave the Roth as a legacy to their heirs, who can then stretch out the tax-free growth over their lifetime.

Participants don’t have to choose one option over the other. Many participants choose to split their deferrals by contributing some on a pre-tax basis and some on a Roth basis, thereby hedging their bets on what future tax rates might bring.

 

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