Congress is working on a new set of tax rules for retirement savers. The bill is called the Secure Act 2.0. The bill has passed the House and looks like it has support in the Senate, so some of this may become law this year.
One of the primary provisions in the bill is the expansion of Roth 401(k) features. The bill, as currently written, would allow employees to have employer matching contributions made to their Roth 401(k) accounts. The bill would also require catch-up contributions for older savers to be made into their Roth accounts.
Why is Congress so enamored with Roth savings features? One of the main reasons is that it accelerates income tax receipts. If you contribute money to a Roth 401(k), you do not receive a current income tax deduction, but the money grows tax-free going forward. If Congress wants you to use Roth accounts and pay taxes now, should you?
The Roth vs. Traditional 401(k) question causes a lot of confusion among investors. But in a nutshell, it’s a simple analysis. The problem is the analysis requires you to make assumptions about future taxes that are not so simple.
The basic rule is that if you will pay a higher tax rate at the time of the contribution vs. the time of your distribution, you should use a traditional 401(k). For instance, if your tax rate today is 32% and in retirement it will be 24%, you should take the deduction now at 32%. Then when you distribute the money, you only pay tax at 24%. Thus, you save 8%.
Conversely, if your tax rate at contribution is lower (say 24%) than your tax rate at distribution (say 32%), then you should use a Roth. Basically, you pay tax today at 24% and avoid paying tax later at 32%. That’s really all there is to it. But, of course, who can predict tax rates years or decades down the road? Therein lies the problem.
There are, however, a few situations where the answer is easier to figure out. If you’re a younger worker just starting in your career, it’s likely the Roth feature will be the better bet. The reason is your income is likely to be lower in your early years and then higher as you advance in your career. Thus, your income tax rate should be lower when you contribute the money vs. when you take it out 40 or more years later.
The other time it’s more obvious is when you might have some sort of a windfall year for income. Let’s say you got a big bonus or had stock options that you exercised, and that extra income pushes you into a higher tax bracket. In that case, a traditional 401(k) contribution will likely make the most sense. You’d be getting a deduction at a higher tax rate and then paying tax on the money at a lower rate when you retire.
And finally, if you happen to consistently be in the top 1% of wage earners, and you believe you will be in the highest bracket as well in retirement, then it may make sense to use the Roth feature. You are paying the same tax rate while working as retired, so it doesn’t really matter, but you at least get the tax-free growth and no required minimum distributions to deal with later in your retirement.
But just about every other scenario is more of a toss-up. Let’s say you are in your mid-40s, married, and in the 22% federal tax bracket, which goes from around $83,000 up to about $178,000 of income. When you retire, maybe your income is still in that range, or maybe it’s higher or lower. Maybe tax rates for that income bracket go down to 20% or up to 25%. Who knows? Those are all reasonable assumptions and there is no way to predict your future tax rate within a few percentage points.
So, what should you do? Well, a reasonable approach, given the uncertainty, is to split your contribution. If you are putting money in a 401(k), consider putting half in the traditional side and get the tax deduction today. Then put half in the Roth side, pay taxes now, but get tax-free growth later.
You can create all sorts of complicated assumptions about your income and future tax brackets, but you are just guessing. Congress can change the rates and brackets at any time, and they do change them all the time. Moreover, while Roth accounts are tax-free now, there is no guarantee they’ll be tax-free forever for every taxpayer. Recently, some Congressional leaders have suggested taxing unrealized capital gains for the wealthy. We’ve never done that before. It’s not likely to pass, but you get the point.
If you are like most people and in the middle of the income tax brackets, consider splitting your contributions. Then don’t think about it much until they change the rules again. If you have any questions or concerns about this potential rule change, consider speaking to a financial advisor.
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