A common question that I am asked by 401(k) participants is whether they should be making traditional 401(k) contributions that are made on a pre-tax basis or Roth 401(k) contributions that are made on an after-tax basis. A thorough analysis of the 401(k) participants' current tax situation and their projected asset level and taxes after retirement should be considered before making this decision.
I have been in meetings with a client and their accountant when discussing this topic. During our meeting, the accountant made the comment to the client, “You should definitely contribute to the Roth 401(k) option. Taxes are going to be much higher in the future.” I was surprised by this recommendation and challenged the accountant’s reasoning. Though taxes could be higher in the future, I think it is best to make financial decisions based on what we know to be 100% true today, not what we think, assume or guess could happen in the future.
The client in this example was in the 24% Federal Tax bracket, so between Federal and State taxes, their total income tax rate was around 28%. Therefore, we know that by contributing $19,500 ¹ to a Traditional 401(k) on a pre-tax basis, they will save $5,460 per year in income taxes.
Will the tax rate for this client be higher than 28% during retirement? We would have to feel quite strongly that the client would have a tax rate of 28% or higher during retirement for them to select the Roth 401(k) option. Solving this puzzle involves looking at projected future income amounts, such as Interest income, Dividend income and Social Security income. Because this client does not own any real estate investments or a business, we can exclude any future passive income amounts.
Assuming that the client will receive a Social Security income benefit of around $50,000 per year, they would have to earn around $150,000 per year in Interest and Dividend income to have a total income tax rate of 28% during retirement. To generate $150,000 in Interest and Dividends in today’s low-interest-rate environment, they would need to have a total portfolio size of around $7,500,000.
Because interest rates might be higher when this client retires, I would error on the conservative side and likely recommend that they contribute to the traditional pre-tax 401(k) option, unless they are projected to have over $5,000,000 in retirement. Making recommendations, as the accountant made above, that are based on assumptions that may sound good on paper or seem logical are often not good alternatives for fact-based analysis customized to an individual’s specific circumstances and situation.
This information should be used for educational purposes only and is not intended to be specific investment planning, retirement planning or tax planning advice. We recommend that you consult with a professional tax advisor or qualified plan consultant before implementing any of the options presented.
¹ The maximum employee elective deferral for contributions to a Defined Contribution Plan for 2020 is $19,500. For participants who are over the age of 50, they can make an additional Catch-Up contribution in the amount of $6,500. So, participants over the age of 50 can contribute a total of $26,000 to a Defined Contribution Plan for 2020.