Here’s a finding I did NOT expect: According to a 2017 research paper at Harvard Business School, employees who have the option to contribute to a Roth 401(k) instead of a traditional 401(k) tend to contribute the same amount to either account. Given that a Roth 401(k) usually results in more money taken out of your paycheck every week or month than a traditional 401(k), that’s unexpected!
Traditional 401(k) contributions are made on a pre-tax basis while Roth 401(k) contributions are made post-tax. So, assuming a given level of cash flow available, most of the time contributions to a traditional 401(k) will be more affordable than contributions to a Roth 401(k) because traditional plans drive your annual taxable income lower. You’ll still have to pay taxes on the contributions later when you retire, but the “taxable event” is deferred.
Take the case of Priya, a 49-year-old single mom. She makes $135,000 a year and lives alone with her son. Not counting her employer’s match, Priya saves $350 per pay period in her traditional 401(k), totaling $9,100 a year. Absent other considerations, her $9,100 contribution reduces her annual taxable income from $135,000 to $125,900. As a result, since her taxable income is less, she will pay less income taxes.
What if Priya were to switch her contributions to her company’s Roth 401(k)? She is considering contributing the same amount: $9,100. However, because contributions to a Roth are post-tax, they would no longer reduce Priya’s taxable income. Thus, she would pay taxes on $135,000 instead of $125,900. Hence, Priya would end up owing more taxes for the year.
A no-brainer for the traditional 401(k), right? Wrong. Roth 401(k)s provide one major advantage. If Priva switched to the Roth and maintained her contribution level, she might end up with more income in retirement as Roth 401(k) distributions in retirement are tax-free, whereas traditional 401(k) distributions are taxed as income. However, switching her contribution to the Roth would be at the expense of her current cash flow. Can Priya afford it?
What if she would reduce her Roth contribution to keep her current cash flow constant? In that case, it is not clear that Priya’s after-tax income in retirement would be higher or lower with a Roth 401(k) than with a traditional 401(k). Answers would require further analysis of her situation.
It’s important to remember that neither Roth 401(k)s nor Roth IRAs are tax-free: they are merely taxed differently. That makes the decision to invest in one or the other an important financial-planning decision: Employees need to understand the benefits and drawbacks of both approaches to make an informed decision that balances current spending desires with future income needs.
According to John Beshears, the lead author of the Harvard study, one possible explanation for his finding is that people are confused about the tax properties of the Roth. Another possibility could be that people have greater budget flexibility than they give themselves credit for. Either way, employees should seek additional support before making this very important decision.
Chris Chen CFP® CDFA is the founder of Insight Financial Strategists LLC, a fee-only investment advisory firm in Newton, Mass. He specializes in retirement planning and divorce financial planning for professionals and business owners. Chris is a member of the National Association of Personal Financial Advisors (NAPFA). He is on the Board of Directors of the Massachusetts Council on Family Mediation.
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