Roth 401K Vs Traditional 401K For High Income Earners

The wealth held within 401(k) plans has experienced an exponential surge over the past two decades. From the year 2000 to the present, the combined assets of defined contribution plans have increased nearly fourfold, soaring from $3.0 trillion to an impressive $11.2 trillion. As a result, a sizable number of people now rely on these programs as their main source of income throughout retirement.

Simultaneously with the widespread adoption of 401(k) plans, the proportion of plans allowing employees to allocate after-tax funds into Roth accounts has also expanded.

As of the conclusion of 2021, approximately 88% of plans gave participants the option to contribute to a Roth 401(k), as reported by the Plan Sponsor Council of America.

However, merely 28% of participants chose to capitalize on this opportunity. Does this mean that workers have missed out? If presented with the choice, should one opt for pre-tax contributions to a traditional 401(k), or should they direct after-tax funds towards a Roth 401(k)?

New Legislation Heightens the Urgency

The urgency of this question has been amplified by recent legislative developments. The passage of the Secure Act 2.0 in late 2022 has introduced a range of significant modifications that impact Roth accounts. These changes encompass:

Allowing employers to provide matching contributions to an employee’s designated Roth account (Section 604). Notably, while contributions to Roths or other non-elective retirement plans are treated as matches, they are not excluded from gross income.

Enabling the Establishment of SIMPLE and SEP Roth IRAs Starting from 2023 (Section 601).

Directing “catch-up contributions” for employer-sponsored retirement plans exclusively into designated Roth accounts for specific high-income earners. This alteration affects eligible participants earning wages exceeding $145,000 from the sponsoring employer, adjusted for inflation, for the previous calendar year, commencing in 2024 (Section 603).

It’s important to note that whether you choose a Roth 401(k) or a traditional 401(k), your investment options remain unchanged. The key distinction lies in taxation.

Traditional contributions grant a pre-tax deduction, and the assets grow tax-deferred until withdrawn from the plan. At that juncture, they become subject to taxation at your ordinary income rate. In contrast, Roth contributions do not provide a tax deduction upfront.

Instead, taxes are paid on the contribution itself. Subsequently, all future growth takes place tax-free, and when you make a qualified distribution, your withdrawal remains untaxed as well.

Which One Functions Best?

While it might seem counterintuitive, contributing an identical amount to either a pre-tax traditional 401(k) or an after-tax Roth 401(k) will result in an equivalent final value in terms of dollars, assuming no withdrawals are made and both maintain the same allocation.

However, all assets are not created with the same impact. Even though the final value appears identical, the worth of Roth dollars surpasses that of traditional dollars. The reason lies in the ability to withdraw Roth assets tax-free, whereas traditional 401(k) dollars must account for taxes, significantly diminishing their value.

Imagine a 40-year-old employee faced with the decision of choosing between a Roth 401(k) and a traditional 401(k) for a $20,000 initial investment.

The projections indicate that both options could grow to $1.19 million over a 25-year period, assuming a diversified mix of 70% stocks and 30% bonds.

However, with a traditional 401(k), the participant benefits from a $20,000 tax deduction, leading to a $8,000 reduction in annual taxes assuming a 40% effective tax rate.

If you were astute enough to invest this $8,000 in a taxable brokerage account, our projections suggest that these funds could expand to $410,000 within the same timeframe.

At this juncture, choosing to contribute on a pre-tax basis to the 401(k) would generate greater “total” wealth on paper. Essentially, even though the sums within your traditional and Roth 401(k) remain identical, you would have amassed an additional $410,000 in a separate taxable portfolio.

Current vs. Future Tax Brackets

One of the big questions to consider is whether you expect to be in a higher tax bracket or lower tax bracket in retirement, experts say. Generally speaking, pretax contributions are better for higher earners because of the upfront tax break, Lawrence said. But if your tax bracket is lower, it makes sense to pay income tax with Roth deposits.

Implications of Traditional 401(k) Assets

On one hand, the value of $1.19 million held within your traditional 401(k) is fully subject to taxation, resulting in an after-tax amount of $714,000 (applying the same 40% tax rate). Combining this after-tax value of $714,000 with the $410,000 in the taxable portfolio yields a total wealth of $1.12 million if you opt for the traditional 401(k) route.

Notably, this amount falls considerably short of the $1.19 million in your Roth 401(k). This discrepancy might raise questions. The difference can be attributed to the tax treatment of money “saved” in a taxable portfolio.

While these assets benefit from more favorable tax rates, they are also subject to annual taxation on interest, dividends, and realized capital gains. In contrast, the assets within the Roth 401(k) enables you to not pay income taxes.

Extending the Analysis: Roth 401(k) vs. Traditional 401(k) Over Extended Periods

Certainly, most investors do not liquidate their entire 401(k) in a single transaction. Therefore, let’s broaden our assessment of the Roth 401(k) versus traditional 401(k) over longer periods of 35 and 45 years.

As we delve into this extended analysis, the advantages of the Roth approach continue to grow evident. Over the course of 45 years, the Roth 401(k) accumulates $620,000 more in wealth, amounting to a notable 17% increase compared to a traditional 401(k) contribution on an after-tax basis.

Considering Retirement Tax Rates: Roth 401(k) vs. Traditional 401(k)

Long-Term Benefits of Tax-Free Growth

Undoubtedly, the longer the Roth account experiences tax-free growth, the more substantial its eventual advantage becomes. However, what if your tax rate diminishes after you retire? To address this scenario, let’s revisit the comparison between the Roth 401(k) and traditional 401(k), but this time, let’s assume that the effective tax rate during retirement decreases to 30%, reflecting a 10% reduction. With Roth contributions, you don’t receive a tax deduction. Instead, you pay taxes on the contribution, but all future growth occurs tax-free and when you take a qualified distribution.

Roth Continues to Outperform

In essence, the Roth strategy maintains its edge (See Display). Over a span of 45 years, the Roth accumulates an additional worth of $200,000, representing a 5% advantage on an after-tax basis.

For the traditional 401(k) to match the Roth in terms of after-tax value within the same timeframe, the tax rate would need to decrease by approximately 14%, as per our estimations.

However, the duration of your investment significantly influences this outcome. Put simply, the more the Roth assets grow over time, the greater the room for the retirement tax rate to decrease, while the Roth still emerges as the superior option.

On the contrary, a shorter investment period makes the final result more susceptible to the eventual retirement tax rate.

Influential Factors in Choosing Between Roth 401(k) and Traditional 401(k)

Multiple Considerations for Your Decision

Making the choice between a Roth 401(k) and a traditional 401(k) involves a multitude of factors, and there’s flexibility to allocate between the two as long as the total doesn’t surpass IRS contribution limits. As you assess your options, take into account the following critical factors:

Time Horizon: Maximizing the Benefit of Roth Contributions

The duration your funds remain within the Roth account significantly impacts the advantages of Roth contributions. The longer these dollars remain untouched, the more substantial the eventual benefit they provide.

Tax Rate: Matching Taxation to Your Situation

Assess your tax rate—both present and projected for retirement. If your tax rate is expected to remain relatively stable or even higher during retirement, the scale tips in favor of a Roth.

The same applies if your current tax rate is lower than anticipated future rates. Conversely, if you anticipate a substantial decrease in your tax rate upon retirement, the traditional 401(k) contribution becomes more favorable.

Savings Power: Tailoring to Your Saving Habits

Consider your propensity to save versus spend. The Roth’s “forced savings” mechanism might resonate if you’re inclined to spend.

Moreover, if you possess the capability to save beyond permissible limits, the Roth presents an advantage. For instance, sheltering $22,500 within a Roth 401(k) equates to saving $35,700 within a traditional 401(k)—an amount exceeding the IRS limit.

Cash Flow: Aligning with Your Financial Flow

Evaluate your cash flow necessities. Some individuals rely on their tax deduction to fulfill other financial obligations. Analyzing your cash flow requirements can guide your choice between the Roth and traditional routes.

State of Residence: Tax Dynamics in Retirement

Delve into the taxation dynamics of your intended retirement state. If that state boasts a lower tax rate compared to your current residence, you can expect an immediate tax reduction. States like California, with a top tax rate of 13.3%, contrast with tax-free states such as Tennessee, Florida, and Nevada.

Exploring the Secure Act 2.0 Changes

The Secure Act 2.0 introduces modifications that warrant a reevaluation of Roth account contributions for many investors. If you’re navigating the decision of a Roth 401(k) versus a traditional 401(k), your Bernstein advisor is equipped to guide you in formulating the optimal strategy tailored to your unique circumstances.

Final Thoughts

In the deliberation between a Roth 401(k) and a traditional 401(k) for high-income earners, several key aspects warrant consideration. The decision hinges on factors such as taxable income and pay income taxes, required minimum distributions, income tax implications, lower tax brackets, the value of a Roth account, and the potential advantages of a Roth IRA. Evaluating these elements will guide high-income earners in determining the most fitting approach for their retirement planning strategy.