Roth vs. Traditional 401(k)

The differences between Roth and Traditional 401(k) extends beyond 401(k)s. To truly understand the benefits and differences, one should also consider Roth and Traditional IRAs.
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Beginning with IRAs first, investors are limited in the amount they may contribute to $6,000 plus a catch-up amount of $1,000 for those 50 years old and older. Traditional IRA savings is generally income tax deductible with a few exceptions: If the saver is covered by a work sponsored retirement plan the deduction is not allowed or their spouse is covered (but the saver is not), the deduction is phased out at certain income limits ($198,000 to $208,000). While Roth savings are not deductible, investors could be limited in their contribution amount at certain income thresholds starting at $125,000 for single filers and $198,000 for married filing jointly.

To contrast this, 401(k) savings offers NO income limitations and higher contribution amounts. When combined with an employer match, the 401(k) is generally more appealing than the IRA. One of the real benefits of the Roth 401(k) is for those earning higher incomes who would generally not qualify to contribute to a Roth IRA. That is, they would be able to contribute $19,500 plus a $6,500 catch-up contribution if age 50 and above, which explains why Roth 401(k) savings is often a common feature in professional organizations or quickly adopted once they are introduced to the concept. Like the Roth IRA, there is no immediate tax benefit for Roth 401(k) savings as those contributions are not deductible. By contrast, however, Traditional 401(k) savings are deductible against income.

Probably the most notable differences between Roth and Traditional 401(k) is the taxation of the funds when withdrawn from the account. Because savers were given a tax deduction for contributions to the Traditional 401(k), income taxes are owed on the contribution and growth once distributed from the account. However, Roth savings is different. Contributions and growth are technically tax-deferred with retirement distributions being income tax-free, so as long as the investor has had the account established for greater than 5 years.

The passage of the SECURE Act in 2019 has caused many advisors to change their tune with regards to which type of savings (Roth or Traditional) makes the most sense for their client. This has to do with how non-spouse beneficiaries inherit the funds from a 401(k) or IRA. In brief, the SECURE Act removed a provision that allowed beneficiaries to stretch-out required distributions over their lifetime (according to a life expectancy table) and replaced it with a 10-year window. When financial projections reasonably suggest that a non-spouse beneficiary could receive an inheritance, advisors usually have a guided conversation to help clients determine how the future taxes will be paid from Traditional 401(k)/IRA savings. In many instances, the Traditional money source is the largest component of an investors net worth and in certain instances, may lead the investor to switch savings from Traditional to Roth for the benefit of lessening the tax burden for those inheriting the funds.

Neal Nolan, CFP®, CPFA, AIF®
Partner, Director of Business Retirement Services


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