The IRS should soon announce inflation-related increases to the annual contribution limits of 401(k) plans, but many people may benefit even more from a quick review of the various tax advantages already provided by these widely available savings vehicles. For starters, 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 end-of-year tax liability.
That additional flexibility in how and when taxes are paid is one of the key factors behind the popularity of a traditional 401(k) arrangement. Further, 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. Moreover, 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 from Social Security and Medicare increases.
It is also worth remembering that when you withdraw money from a traditional 401(k) plan you are subject to both federal and state income taxes. This means that individuals who spend their working careers in high-income-tax states but then retire in a low- or no-income-tax state may have the ability to reduce or outright avoid any state income tax liabilities. On the other hand, a Roth 401(k) subjects your retirement dollars to both federal and state income taxes today in return for “tax-free” income during retirement. Since state-level income tax rates can vary significantly, the effect on a person's retirement can be huge. Individuals must therefore consider not just their expected federal tax bracket in old age but also the tax rates in the location they intend to retire. Additional clarity on these and other retirement issues will as usual be available by consulting with a professional financial advisor.
From a simple behavioral finance standpoint, though, nudging Americans into a Roth-style 401(k) may be ideal because academics have argued that such plans can generate a much larger retirement nest egg since people tend to save at the same rate regardless of what style 401(k) they use. Indeed, Harvard Business School’s John Beshears told The Wall Street Journal that, “The American tax system is extremely complicated. People very reasonably use rules of thumb to guide their financial decisions, especially in the face of complexity. Some common rules of thumb for saving in a 401(k) are to contribute the amount necessary to earn the maximum employer matching contribution, or to contribute the maximum amount allowed in the plan. Another ubiquitous suggestion is to save 10% of pretax income. If they switch over into a Roth and do not adjust their rule of thumb, they’re in effect saving more.”
Sources: U.S. IRS, Fidelity, CNBC, HBS, Wall Street Journal
Post author: Charles Couch