We found our disciplined friend, who thanked us, on behalf of his son, for having guided him in the decision about the savings plan. However, he tells us: my son is being asked if he prefers to invest in the traditional 401k or a Roth, what do you think?
Roth plans originated in the Taxpayer Relief Act of 1997 and were offered beginning in 1998. Its creation sought to expand access to individual retirement accounts (IRAs[1]), without affecting tax collection too much. For this reason, Roths operate differently from traditional ones, since contributions are made with money that has already paid taxes. The 401k version of Roth plans has a more recent history, originating from the Economic Growth and Tax Relief Reconciliation Act of 2001 and were first offered in 2006.
In a traditional 401k, contributions are made on a pre-tax basis, and taxes are deferred until distributions are made. In a Roth 401k, by contrast, taxes are paid before contributions are made, and from that point on, they will not be paid again[2]. Unlike traditional 401ks, Roth 401ks do not include requirements to make minimum annual distributions (RMDs[3]) starting at a certain age[4].
Roth 401ks provide the same tax-free growth benefit that traditional 401ks provide, but with the added incentive that the accumulated amount will never pay taxes. The dual benefit of growing contributions and making distributions without incurring taxes make the Roth 401k an ideal vehicle for long-term accumulation.
From the above, it makes sense for a young person and/or subject to a relatively low marginal tax rate to make contributions to a Roth 401k. A person subject to high marginal rates might prefer to contribute to a traditional 401k and defer taxes, hoping to pay them at a time when their marginal rate is lower. The marginal tax rate not only increases according to the level of income, but can be altered by changing the Law. For example, a government facing high spending needs might want to raise marginal rates to raise higher taxes. For this reason, the decision to contribute to a traditional or Roth 401k will depend primarily on personal income expectations and changes in legislation. Given the uncertainty, it is recommended to diversify retirement savings to include traditional and Roth accounts.
To conclude, Roth IRAs are the personal version of Roth 401ks (which are always offered by the employer). The main differences[5] between them are certain limitations on their use according to the taxpayer’s income and the maximum amount of the annual contribution. In both cases, the Roth 401k is markedly superior to the Roth IRA because its use does not include income limitations, and the maximum annual contribution is more than 3 times higher.
Finally, and in the case of our friend’s son, he will most likely prefer to make contributions to the Roth 401k, taking advantage of the fact that his marginal rate at the beginning of his career could be relatively lower. In the future, contributions may be redirected to a traditional 401k or split between the two models to achieve long-term savings under different tax regimes.
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your particular situation.
[1] Individual Retirement Accounts
[2] Subject to restrictions such as having had the account for 5 years and having reached 59.5 years.
[3] Required Minimum Distributions.
[4] This is due to a change contained in the Secure Act 2.0 and effective from 2024.
[5] https://www.irs.gov/retirement-plans/roth-comparison-chart#:~:text=Roth%20IRA%20contributions%20are%20made,made%20with%20before%2Dtax%20dollars.&text=No%20income%20limitation%20to%20participate.