Personal Finance

If you like paying hefty tax bills, stick with your regular 401(k)

Key Points
  • Most retirement plans now offer the option of saving in a Roth 401(k).
  • Many plan participants are sticking with a traditional 401(k), rather than using Roth 401(k).
  • Missed opportunity: Saving in a Roth 401(k) today likely means a lower tax bill in retirement, and more estate-planning possibilities.
The bad things good people do with their 401(k) plans
The bad things good people do with their 401(k) plans

If you are looking forward to a retirement spent paying hefty tax bills, a traditional 401(k) plan may be your twisted ticket to happiness.

Once you turn age 70½, you are forced to start taking money out of your traditional 401(k) annually — the more polite terminology is "required minimum distribution" — and every penny you withdraw will be taxed as ordinary income.

The perverse reality is that the more you have socked away for retirement in traditional accounts, the bigger your RMD tax bills will be, even if you don't need the cash to cover living expenses. And those RMDs just might boost your taxable income to a level that triggers owing more tax on Social Security benefits and being hit with a higher Medicare premium.

If that's not your idea of retirement bliss, chances are pretty good there is a great tax-savings move right under your nose that you're mistakenly passing up.

Vanguard reports that nearly two-thirds of 401(k) plans it administers now have the option of saving in a Roth 401(k), rather than the standard traditional 401(k).

With a Roth 401(k) contributions are made with after-tax income. The payoff comes in retirement when you can either skip RMDs completely (more on this in a second) or take distributions without owing a penny in tax. Yet less than 15 percent of retirement savers with the ability to save in a Roth 401(k) are taking advantage of the Roth option.

Taxes are the most expensive thing in retirement.
David Hays
president, Comprehensive Financial Consultants

"I'm from the Midwest, so I use a farm analogy: Do you want to pay tax on the seed or on the harvest," said David Hays, president of Comprehensive Financial Consultants in Bloomington, Indiana. "The only rational answer is that you pay it on the seed."

That is, take your tax hit early, by using a Roth 401(k) that is funded with after-tax dollars — paying tax on the seed contribution — with the eventual payoff that you will not owe a penny of tax when it's time to harvest your savings, in retirement.

The myth of the lower tax bracket

While Roth 401(k) plans are positioned as ideal for millennials who have yet to hit their peak earnings (tax rates), 40- and 50-somethings who've been using a traditional 401(k) for a few decades can add valuable tax diversification by switching over and doing some Roth saving.

"Taxes are the most expensive thing in retirement," said Hays. "Think about it, you pay 30 percent or so every time you want to access your money.

"The Roth 401(k) is an absolute necessity," he added. "It allows you to position yourself so you are not forced to access your tax time bomb in retirement when you need money. "

For the record, anyone can contribute to a Roth 401(k). There are no income limits. Employer matching contributions will continue to be made into a traditional 401(k) account.

A common argument for sticking with a traditional 401(k) is that reducing your taxable income this year with your pretax contributions is more valuable to you if your expectation is that you will be in a lower tax bracket in retirement.

Be careful with this assumption. If the bulk of your retirement savings are in traditional 401(k) plans and individual retirement accounts, the RMDs are likely to keep your rate from plummeting, especially once you add in other income sources such as Social Security and, perhaps, a pension.

How Much More Spendable Income Can a Roth IRA offer over a Traditional IRA?

Change in tax rate 25 years old 30 years old 35 years old 40 years old 45 years old 50 years old 55 years old 60 years old 65 years old
Stays the same18%17%15%14%13%11%9%8%6%

Source: T. Rowe Price.

A few years ago, T. Rowe Price ran the numbers to see how much more income you might have in retirement if you saved in a Roth IRA rather than a traditional IRA, assuming different retirement tax rates. The concept is the same for 401(k) plans.

If your retirement tax rate stays the same as your current tax rate, T. Rowe found that a Roth is the better investment. A 40- or 50-something would need their retirement tax rate to be 8 to 10 percentage points lower to justify sticking with the traditional today. Unless you're making a move from Fifth Avenue to off-the-grid, that seems unlikely.

You also might want to stop taking long-term retirement planning advice from your tax pro.

"We have clients who tells us their CPA insists the traditional is the better option," said Elijah Kovar, a partner at Great Lakes Financial in Minneapolis. "Of course they do.

"A CPA is tax-reactive; they look at last year's returns and search for ways to reduce your current tax bill," he added. "We are taking a bigger-picture look on how to minimize taxes in retirement."

Rare heir bonus

Another benefit of saving in a Roth 401(k) is that once you retire, you can roll over the account into a Roth IRA. No taxes are due on that move. And once the money is in the Roth IRA, you have officially escaped the grip of Internal Revenue Service RMDs.

If you want to spend some of the money, your withdrawals will be tax-free. Or you can just let the money keep growing free of taxes for your heirs. Yes, they will be required to take distributions immediately after you die, but they, too, will owe no income tax on the distributions as long as you had the IRA for at least five years.

Kovar notes that the Stretch IRA is on the hot seat in Washington. If that tax break is reduced or eliminated, it would trigger bigger tax bills for anyone inheriting traditional (read: taxable) IRA assets. "We're planning on the Stretch IRA going away," said Kovar. "That makes having money in a Roth even more compelling."