Roth vs. Traditional 401(k): Some of Both May Be Best

The debate about whether the Roth or traditional 401(k) provides the biggest tax savings is not always black and white, and combining the two strategies may be the best solution for many investors.
Whether the Roth or traditional plan produces the largest tax savings comes down basically to assumptions about current and future income tax rates. Essentially, if the investor believes he or she will be in a higher income tax bracket in retirement, the Roth wins. If the investor believes he or she will be in a lower income tax bracket in retirement, the traditional plan wins.
It sounds simple but because of our graduated income tax structure, many investors will be in multiple income tax brackets once they retire. Therefore, funding both a traditional and Roth 401(k) may provide them with the best opportunity to maximize their tax savings.
For example, assume your client is a 64-year-old, married investor with taxable income of $120,000 who contributes $15,000 to his 401(k). The client plans to retire at 65 and begin taking distributions. At $120,000 of income, the client is subject to the 25% federal income tax bracket on the 401(k) contribution. On approximately the first $65,000 of taxable income in retirement, he is only subject to the 10% and 15% federal income tax brackets. He has Social Security of about $20,000, which leaves $45,000 of distributions from his retirement plan that will be taxed at a rate lower than the rate that applied on the contribution. As a result, for these distributions, the traditional plan provides the greater tax benefit.
But as distributions increase, and the retiree creeps into the higher income tax brackets, the traditional plan begins to lose some of its punch. This is where the Roth 401(k) account comes into play. If the investor had been funding both the traditional and the Roth plans, he could use his distributions from the traditional plan to fill up the lower income tax brackets. Then, once the retiree hits the higher income tax brackets, he can shift to take the tax-free Roth 401(k) distributions. This will lower the retired investor’s effective tax rate and allow the retiree to benefit from both the traditional and Roth tax features.
There are, however, two exceptions to the split funding approach where the odds may favor fully funding the Roth. First, for investors who are in the lowest income tax brackets today (10% and 15%), the odds are pretty good that they will be in a higher income tax bracket once retired as their incomes and assets grow. So, funding the Roth may be their best choice.
Second, for those in the highest income tax brackets (33% and 35%), there is a good argument to be made that future income tax rates may be higher. Thus, using the Roth and paying the tax today may be a better choice.
But most investors are somewhere in the middle. They fall into the 25% and 28% tax brackets, which cover household incomes of approximately $65,000 to $200,000. Therefore, it makes sense for many investors to consider building assets in both traditional and Roth 401(k). By splitting the funding, the investor can use the traditional plan’s tax savings for distributions that may be taxed at a lower rate in retirement. The Roth assets can then be used for distributions that move the investor into the higher income tax brackets. The Roth funds, once rolled to a Roth individual retirement account, are also not subject to the required minimum distribution rules, which may allow taxpayers to avoid larger income tax bills as they age.
The 401(k) plan rules allow investors to allocate their funds between the Roth and traditional plans however they see fit. For older investors who have sizeable amounts in their traditional plans already, it may make sense to shift future contributions to the Roth 401(k). This will allow them to build a pool of tax-free assets to complement the tax-deferred savings they already have. For younger investors, it may make sense to consider splitting the funds between both plans.
The bottom line is that both the traditional and Roth plans offer important tax benefits. For most people, it is not a choice of one or the other. While each investor’s circumstances are unique, building assets in both plans may offer many investors the best opportunity to maximize their tax benefits and keep more of their hard-earned money.