Some of my readers may remember the vintage television commercial for a major brand of engine oil filters. Advocating the advantages of paying a little now in preventive maintenance over more expensive repairs later, the seasoned-looking mechanic peers into the camera and says, “You can pay me now or pay me later.”
A similar logic applies to the issue of taxes and your employer-sponsored retirement plan. You can make contributions to a Roth 401(k) and pay the taxes now, or you can contribute to a traditional 401(k) and pay them later, when you withdraw funds in retirement. In this article, we’ll explore the advantages of the former option: paying taxes now on the money you deposit in a Roth account, with the potential of building a larger source for tax-free income in future years.
By the way, most of what is said here about 401(k) accounts also applies to 403(b) accounts, the usual employer-sponsored option for the many STEM professionals working for non-profit educational or research institutions.
Roth vs. Traditional (“Pre-tax”) 401(k): The Basics
The principal difference between a traditional 401(k) and a Roth 401(k) is when the funds are taxed; contributions to a traditional account are “before-tax”; that is, the money deposited in the account is deducted from your taxable income for that year, so you don’t pay taxes on it now. But then when withdrawals are made in retirement, they are taxed as ordinary income (“pay me later”). Roth contributions, on the other hand, are “after-tax”: there is no tax deduction for the contribution, so you put money in after you pay taxes on it (“pay me now”), but when funds are withdrawn in retirement, there is no tax applied to the original amount you contributed. The biggest tax savings of a Roth retirement account, however, is that the earnings don’t get taxed either, so you get fully tax-free growth on your initial contribution.
Another difference between the two is when funds must be withdrawn from the account. Traditional 401(k)s have required minimum distributions (RMDs); when the account owner reaches age 72 (if born in 1950 or earlier), 73 (if born 1951–59), or 75 (if born in 1960 or later), they must begin withdrawing a minimum amount and paying taxes on the withdrawals. Roth accounts, by contrast, have no RMDs; the funds can be left in the account as long as the owner wants, which makes them a nice way to leave a tax-free legacy to your heirs if you don’t need the funds yourself.
Thus, for most plan participants, the issue of choosing Roth vs. pre-tax, or traditional contributions boils down to which alternative will result in paying the least amount in taxes.
A Hidden Advantage of Maximizing Roth Contributions
One additional big plus for folks who are maxing out their contributions to the Roth side of their retirement plan is that the maximum allowed contribution to a 401(k) is the same in dollar terms whether it is pre- or post-tax. Which means that if you have the cash flow to afford it, you are actually putting more money to work for your retirement by maxing out the Roth side. How is this possible? If we compare the total picture of taxes and what gets into the retirement plan to grow for the future, the 2026 maximum contribution of $24,500, taken out of your salary and contributed to a pre-tax 401(k) includes the future taxation that gets taken out on withdrawal. But the $24,500 Roth contribution that goes into the 401(k) is accompanied by the additional taxes on that amount that also get taken out of your salary, maybe another $6,000 or so for those in a combined Federal and State marginal tax bracket of 25%. So you are effectively adding more like $30,000 of your current income to your retirement savings. The math on this can be a bit hard to understand, but the graphic below can help. If it still doesn’t make sense, be sure to reach out and I can help with that!
There are several scenarios where paying taxes now on a Roth 401(k) contribution can result in accumulating more after-tax wealth in retirement. These include:
- Younger STEM professionals near the beginning of their careers who are likely to be in a lower tax bracket now;
- Those with additional sources of retirement income (pensions, rental properties, taxable investments, etc.) that may push them into a higher bracket in retirement;
- Those who anticipate generally higher tax brackets in the future;
- As illustrated above, those with sufficient cash flow to max out their Roth 401(k) contributions and who want to maximize the potential growth of their retirement savings.
For persons in these categories, choosing Roth 401(k) retirement plan contributions, while not providing a tax deduction in the present, may produce a better financial situation in retirement, and an overall lower lifetime tax bill.
Employer 401(k) Matching and “True-Ups”
There’s another benefit to employer-sponsored plans that we haven’t mentioned yet: matching contributions from the employer. Depending on the specifics of the employer plan, participants who contribute to either the traditional or Roth side of their 401(k) plan may be eligible to receive matching contributions to their accounts from the employer, up to an amount specified by the plan. This is essentially free money; a tremendous benefit and incentive for qualified employees. If your employer matches some portion of your contributions, it is important that you are contributing at least the required amount to receive the full employer match, so long as your budget will allow it. Failing to do so means leaving free money on the table instead of in your retirement account, working for you.
There is one tricky way that you can miss out on some of the employer match you might think you are entitled to based on your total salary contributions. Because employees can change the amount they are contributing during the year, the employer match is generally calculated on each paycheck. If you contribute the required amount to earn a match in a given pay period, you get the matching contribution. However if you don’t contribute to the 401(k) for some pay periods, you will not get any match for those pay periods either, even if overall you have put in enough to meet the required percentage. This is where a little known feature of many, but not all, 401(k) plans comes into play: the “true-up.” This provision, if offered by the specific plan, helps to ensure that employees receive the full employer matching contribution to which they are entitled.
As an example, suppose your company matches 100% of the first 4% of your annual salary you put in. You put in 10% for the first half of the year and then stop, for whatever reason. You have contributed 5% of your annual salary, but your employer has only put in 2%. If your plan has a “true-up” provision, the remaining 2% match that you are entitled to because you put in at least 4% of your salary will be added as a lump sum early in the following year.
True-ups can happen for a variety of reasons. An employee might front-load their contributions so that they max out their allowable contributions early in the year. If their plan doesn’t automatically switch their contributions over to a post-tax traditional plan, then their contributions will stop and so will the match. An employee can face unexpected costs and pause or cut back contributions for some period of time. Or an employee receives a bonus midway through the year and decides to make a large, one-time contribution using those funds. In all of these cases, contributions aren’t spread evenly over the year, which could prompt a true-up, if the plan offers one.
So before making decisions about what to contribute to your 401(k) plan and when during the year, it is very important to review plan rules about employer matching contributions and the availability of a true-up provision. And if you are a Federal employee who participates in the Thrift Savings Plan (TSP) with a match, you must be very careful how you arrange your contributions over the year, because it does not have a true-up feature. If you miss out on a match because your contributions stopped for whatever reason, that match is gone.
Choosing the Right Investments
Finally, let’s discuss 401(k) investment selection. Depending on the options offered by your plan, you should generally build a diversified portfolio of low cost mutual funds that mixes stocks and bonds to produce the overall potential for returns that you need to meet your retirement goal, with the level of volatility where you stay invested and let the markets work for you.
Your selection should also take into account your age (i.e., years until retirement). Those with more years until retirement can likely benefit from assets that, while more volatile in value, have the potential for higher rates of growth over time. Those nearing retirement, on the other hand, may prefer investments with less volatility and a greater focus on providing income. Many plans offer options that include:
- Target date funds—designed to become more conservative as the retirement date nears; you would choose a fund with a target date nearest your anticipated year of retirement (a good option for those who want to “set it and forget it”);
- Index funds—designed to track the performance of a major financial index such as the S&P 500 (a good way to get the overall performance of a particular market, usually at a low cost);
- Equity (stock) funds—hold a selection of different stocks, usually diversified over a number of companies, sometimes with broad market focus, like US stocks overall, sometimes with a more narrow mandate, like small US companies;
- Fixed-income (bond) funds—generally less volatile than equities but also with lower potential retusn, focused on generating interest income.
One risk to watch out for is putting a significant amount of your savings into your company stock. This can be very attractive if the company is doing well, but because your current income is also dependent on that continuing, you are creating concentration risk by “putting too many eggs in one basket.” You should also rebalance your account at least annually to maintain your desired allocations to stocks, bonds, and cash, since one asset class usually performs better than the others. If you are not using a target date fund that does it for you, it’s also important to adjust your investment strategy periodically to match your changing goals and retirement timeframe.
At Equila Financial, we work with clients to engineer individualized approaches to retirement funding. If we can help you better understand and align your choices, please get in touch.
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