6 Reasons High-Earners Should Love Their Roth 401k
Are you being penny wise & pound foolish with your tax strategy?
Conventional financial advice says we should reduce our current tax bill as much as possible (within the rules of the IRS code, of course), and then defer paying the tax for as long as possible. The theory is that doing so allows us to keep more of our money longer so we can use it to generate a return. Generally speaking, this holds true, particularly when you’re a high-income earner who’s in a high marginal tax bracket. However, I’m going to lay out why it might make sense for high-income earners to shun this approach and intentionally pay more in taxes today by making Roth 401k contributions – instead of Traditional contributions – to their employer-sponsored qualified plans.
EMPLOYER-SPONSORED RETIREMENT PLANS
The most common employer-sponsored qualified plans are 401k plans for private-sector employees and 403b plans for public sector employees. Both are similar in a number of ways. They are popular because they allow employees to easily and cost-effectively save and invest for their future through automatic contributions from their paycheck. Additionally, Traditional contributions provide an upfront tax break. Regardless of whether you itemize or use the standard deduction, anyone with access to an employer-sponsored plan can contribute up to $19,500 in 2020 and reduce his or her federally taxable income by the amount they contribute. Easy to set up – check. Automated contributions – check. Major upfront tax benefit – check. With all of the benefits associated with Traditional contributions, it begs the question: Is there any reason why a high-income earner would choose NOT to make Traditional contributions? Yes. Continue reading.
ENTER THE ROTH 401k/403b
Almost 80% of these qualified plans now offer a Roth option for employee contributions. The main difference between Roth 401k contributions and Traditional 401k contributions is when you owe federal income tax on the money. When making Traditional contributions, you get an upfront tax benefit because your taxable income is reduced by the amount you contribute. For example, if you’re in the 32% marginal tax bracket and you contribute the maximum $19,500 contribution for 2020, you would reduce your 2020 income tax bill by $6,240 ($19,500 x 32%) which is significant savings to be sure. It isn’t until you begin withdrawing your money (after 59.5 years old to avoid a 10% penalty from the IRS) that your withdrawals are taxed to you as regular income at whatever your marginal tax rate is for that year.
When you contribute to a Roth 401k/403b the money is taxed in reverse. You’ll owe federal income tax on the amount you contribute for the year the contribution was made. However, assuming some basic conditions are met, you’ll never owe the IRS income tax on that money, ever again. So, if you’re in the 32% marginal tax bracket and you contribute $19,500 to your Roth account in 2020, you’d owe $6,240 in federal income tax in 2020; however, the IRS will never again be able to tax that money again or the decades of compounded growth that is generated over the years! This benefit cannot be overstated!
OTHER ROTH BENEFITS
There are other benefits to having your money in Roth accounts. First, once you retire and you roll the Roth 401k or 403b into a Roth IRA, you never need to take a Required Minimum Distribution (RMDs). This means potentially decades more tax-free growth and no risk of forced selling in a down market! Second, Roth withdrawals don’t count towards your income when determining how much you earn in retirement, and thus, what percentage of your Social Security benefits are taxed. This could mean potentially dramatic tax savings on monthly Social Security income checks. Similarly, withdrawals from Roth accounts do not count towards your income when determining how much you have to pay for the health insurance portion of your Medicare coverage (Part B). Third, Roth accounts avoid a huge new issue that’s part of the recently enacted SECURE Act that requires non-spouse beneficiaries of inherited Traditional IRAs & Traditional 401k/403b accounts to withdrawal the entire balance of the inherited account within 10 years of the inheritance and pay income tax on those amounts in the year(s) the money is withdrawn. The resulting tax bills could be extremely costly to higher earning child beneficiaries of these accounts. It’s a non-issue for Roth account beneficiaries because they are not taxed on money withdrawn from Roth accounts. Lastly, Roth accounts provide tax diversification for investors who’ve relied heavily on Traditional 401ks and IRAs for their retirement savings.
ARE ROTH 401k CONTRIBUTIONS RIGHT FOR YOU?
The question you need to ask yourself before deciding whether you should make Roth or Traditional contributions is this: Is it more important to minimize how much I pay in taxes this year OR minimize how much I pay in taxes over my lifetime? As a CERTIFIED FINANCIAL PLANNER™ professional and overall finance nerd, I will emphatically tell you that you should focus on minimizing your lifetime taxes. The easiest way to figure out how to do that is to ask yourself which you think is going to be higher: your marginal federal income tax rate this year, or your marginal federal income tax rate when you withdraw the money in retirement? Most people can figure out the rate they’re going to pay this year pretty easily. Unfortunately, it’s not so easy to know what rates you’ll face in the future. That depends on a number of factors like your total income in retirement, the sources of your income, the value of your Traditional IRAs & 401k/403b accounts, and perhaps most importantly, the federal income tax brackets and rates at that time.
6 REASONS HIGH-EARNERS SHOULD CONSIDER ROTH CONTRIBUTIONS
1. Tax rates are going to go up over time. Consider the following: Relatively speaking, we’re currently in a very low-income tax rate environment – particularly those in the highest tax brackets. Our national Debt continues to skyrocket to all-time highs with no signs of slowing down despite our economy doing very well. We have a Democratic Party that is increasingly warming up to expensive policy issues like subsidizing college tuition and offering universal healthcare. And, we already have entitlement programs like Social Security that are underfunded and in desperate need of some sort of an overhaul in order to remain viable, particularly as baby boomers increasingly leave the workforce and begin to take their benefit payments. For these reasons and many others, the current, low-tax environment simply can’t continue over the long run. Rates are going up. It’s just a matter of when, not if.
2. The current TCJA tax cuts are scheduled to go away in 2026. This means that even if your income remains the same in 2026 as it did in 2025, the majority of Americans will pay a significantly higher tax bill after tax rates revert back to 2017 levels. Analysts project that the TCJA cuts are likely to sunset even sooner if Democrats do well in the upcoming election cycle in 2020.
3. You expect your earnings to grow throughout your career. Despite the fact that you may be earning a lot this year and it’s painful to pay 32% or 35% in federal taxes, if you’re successful and you expect continued income growth over your career, it stands to reason that you should expect your income to push you into even higher tax brackets over time.
4. You already have a large balance in your Traditional IRAs & 401k/403b accounts. If this is the case now and you’re on the younger side, by the time you reach age 72 the magic of compounding will have resulted in your balance being considerably higher! Age 72 is when the IRS will start forcing you to take out Required Minimum Distributions from your account so they can finally tax this money. The higher your Traditional account balance, the more you’ll be forced to withdraw every year for your RMDs which, in turn, can push your taxable income into higher tax brackets. As such, the sooner you can start diverting investment dollars into Roth accounts to let the compound growth occur there instead of in your Traditional accounts, the lower your taxable RMDs will eventually be which will hopefully leave you in a lower marginal tax bracket.
5. You’re RMDs and other income will cause your Social Security payments to be federally taxable. You might think your Social Security benefits will be tax-free since they’re paid to you by the government, but unfortunately, you’d be wrong. If you’re married and file jointly with taxable income over $44,000, you’re looking at up to 85% of your Social Security benefits being taxable. Taxable income between $32,000 & $44,000 means up to 50% of your S.S. benefits are taxable. Any income you receive from Pensions, RMD’s from Traditional retirement accounts, income from taxable accounts, and any other sources of taxable income all count towards these income thresholds. Money taken from your Roth accounts, however, is NOT included when calculating your income level since the money is not taxable.
6. You want greater control of your taxes in retirement. If most of your retirement investments are currently in tax-deferred accounts that are taxable upon withdrawal, you can benefit tremendously by diversifying and building a pot of tax-free investment assets as well. This will give you a huge extra degree of control over how much tax you’ll have to pay each year, what rate you’ll pay, how much of your Social Security will be taxed, in addition to having some big estate planning benefits. Tax diversification is an extremely valuable tool in retirement.
If you’re a high-income earner, it’s tempting to reduce your taxable income by making Traditional contributions to your employer 401k or 403b. However, if any of the above reasons above resonates with you and your financial situation, you should think carefully about whether making Roth contributions might actually be the better long-term decision to minimize your lifetime taxes, maximize your wealth, and plan for a stress-free retirement.
If you would like to learn more, please don’t hesitate to get in touch.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Robert Stromberg, and all rights are reserved. Read the full Disclaimer