Millions of Americans use 401(k)s as a retirement saving tool, and one of the main reasons why is that these plans can provide their users with a variety of tax advantages. For example, participants in a traditional 401(k) will contribute pre-tax earnings to a retirement plan where the funds will grow on a tax deferred basis. The account owner can start to receive “qualified distributions” after reaching the age of 59½ when these withdrawals will be taxed as ordinary income. Since workers participating in a traditional 401(k) set aside a portion of their wages before any federal and state income taxes are withheld, the money pulled from their take-home pay and put into the plan basically provides them with more control over their periodic tax withholdings and their end-of-year tax liability (which could bump them down to a lower tax bracket). That additional flexibility in how and when taxes are paid is one of the key factors behind the growing popularity of a traditional 401(k) arrangement.
Moreover, many Americans will likely have a reduced income once they retire. Since this would put them into a lower tax bracket than when they were fully-employed, the earnings from their tax-deferred 401(k) plan during retirement could wind up being taxed at a much more favorable rate. However, for savers who anticipate being in a higher tax bracket later in life, a Roth 401(k) is often considered a better option because these plans allow participants to potentially reduce their post-retirement tax liability through paying taxes as they contribute rather than when they start to make withdrawals. To put this another way, Roth-style accounts provide a way to lock in current tax rates and hedge against an unexpected tax rate spike, a growing risk as the fiscal strain associated with Social Security and Medicare continues to increase. A report from the Vanguard Group found that participants who utilize a Roth-style 401(k) tend to be younger and shorter-tenured employees, which makes sense since this is the ideal structure for individuals with a very high probability of winding up in an upper income (tax) bracket down the road.
Similarly, research from Wells Fargo found that overall Roth 401(k) usage is on the rise but Millennials, who are in most cases now paying income taxes at the lowest rate of their lives, are more than twice as likely as Baby Boomers to currently be utilizing a Roth-style retirement saving plan (16 percent versus 7 percent). For many individuals, though, it is challenging to know exactly what their future tax rate schedule will look like. This uncertainty arises because not only can it be very difficult to predict what one’s income level will be later in life, but also because tax rates in the U.S. have a history of undergoing considerable changes. The marginal rate for a single taxpayer with an inflation-adjusted annual income of $100,000, for instance, has changed 39 times since the introduction of income taxes in 1913, and has ranged from 1 percent to 43 percent. In fact, the top tax bracket was above 90 percent for roughly 15 years in the mid-20th century.
Fortunately, a study by a group of academics argues that most savers, even those with higher-incomes, may be able to achieve a better overall retirement outcome by using a mix of assets in traditional and Roth accounts. Specifically, the researchers simulated millions of saving strategies for potential retirement scenarios over a 30-year time horizon. Although the study’s authors were not yet able to produce a generalized formula for an optimal strategy, they could still conclude that most investors should diversify between traditional and Roth accounts. The researchers also stressed that the “Results are of practical importance to employers and regulators who determine the retirement savings options available to employees. In particular, broadening access to Roth versions of workplace accounts would provide investors with important tools for managing their exposures to tax risk. Given that these accounts are available under current regulations, encouraging the widespread adoption of, and education about, employer-sponsored Roth plans could substantially improve investors’ welfare.”
Sources: Vanguard, Wells Fargo, NAPA, Bloomberg, SSRNPost author: Charles Couch