By Robert L. Warner, Managing Director – The Pilot Program, Johnson Financial Group
This article is part of a continuing series of articles about retirement planning.
There are several tax deferred, qualified retirement programs available to employees in the private and government sectors today. With these different programs and the many variables affecting each, it can be a formidable exercise to sort through the entire list. So this brief discussion will be restricted to the considerations that can affect the choice of participating in one or both of the 401(k) options—the traditional 401(k) and the Roth 401(k). Converting an existing traditional 401(k) to a Roth 401(k) is covered elsewhere.
The traditional 401(k) is funded with pre‐tax tax dollars which lowers current income and additional post‐tax dollars, if desired, while the Roth 401(k) is funded with only post‐tax dollars. Employer‐matching contributions can be provided only for a traditional 401(k), but are not available for a Roth. Contribution limits are aggregated for both plans and are limited to $18,500 (plus an additional $6,000 if age 50 or over) for 2018.
Pre‐tax contributions and earnings in the traditional 401(k) are tax deferred and taxed at distribution. Post‐tax contributions in the traditional 401(k) remain tax free, but their earnings are taxed at distribution.
Contributions and earnings in the Roth 401(k) are tax free at distribution if the account is held for at least five years by age 59 1/2. That five year restriction also applies, if, for example, the account is opened at calendar year age 58. In that case the tax‐free benefit wouldn't start until calendar year age 63. Remember from above that matching funds provided by an employer to the Roth 401(k) must be allocated to the traditional 401(k) portion of the account. Therefore, the employer match and earnings on the match are taxable at distribution.
Distributions (both plans) without penalty:
Owners of traditional 401(k) or Roth 401(k) accounts must begin Required Minimum Distributions (RMDs) the year they reach age 70½. Note that the Roth IRA does not have an RMD requirement during the life of the owner which is different than the Roth 401(k) rule.
Understanding the differences between the two plans is one of the keys to determining the best plan/combination of 401(k) options when considering each individual's financial situation and objectives.
Elective deferrals to the traditional 401(k), in most cases, will result in a reduction of current income and lower taxes. Since Roth 401(k) contributions are post‐tax those contributions and earnings on those contributions are tax‐free at withdrawal; tax rates, current age and income at withdrawal will be factors to consider. Predicting tax rates and income, especially many years in the future, can be tricky. If expected tax rates at withdrawal are expected to be lower than current rates, then the traditional 401 (k) probably makes more sense. Conversely, higher rates at withdrawal favor the Roth 401(k).
Both the traditional and Roth 401(k) plans have RMDs. RMDs from traditional 401(k) plans are taxable while qualified withdrawals from Roth 401(k) plans are tax‐free. Therefore, if reducing taxable income at withdrawal time is a consideration, then the Roth 401(k) has the advantage.
The two considerations above, of course, are only part of the picture. The complexity comes from trying to predict the future. Depending on the other variables involved in each individual's financial situation, it may be beneficial to consider splitting contributions between both accounts. That avenue could provide some flexibility with regard to tax management at withdrawal as well as hedge against being wrong on predicting the tax environment in the future.
Regardless, the prudent course is to consult with your financial and tax advisors to make sure all of your personal financial elements are considered in making the choice/choices. Revisiting those choices on a regular basis is also recommended.
Johnson Financial Group and its subsidiaries do not provide tax advice. Please consult your tax advisor with respect to your personal situation. Wealth management services are provided through Johnson Bank and Johnson Wealth Inc., Johnson Financial Group companies. Additional information about Johnson Wealth Inc., a registered investment adviser, and its investment adviser representatives is available at https://www.adviserinfo.sec.gov/. NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE