To Roth or Not to Roth in Your 401(k)? It’s All About the Earnings

Monday, April 26, 2021

Jim Sampson, Business Contributor

 

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Since 2006, 401(k) and 403(b) plans have had the ability to add a Roth component inside the plan. And while adoption of this feature has picked up amongst employers, usage is still fairly low compared to adoption in IRAs. So what is holding employers back? Here are a few common misconceptions about Roth 401(k)s.

Roth contributions will make my plan more difficult to manage. Adding Roth is simply an additional deduction code that payroll companies will add to their systems, making this very simple to administer. Record keepers are all able to add and track this feature as well.

My employees won’t understand how it works. Employees are very familiar with Roth IRAs. In fact, many have them. And if they don’t want to use it, they can still use the traditional, pre-tax approach. 

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Roth is just for IRAs. The big misconception here is that when people hear “Roth,” they often think of Roth IRA. The Roth 401(k) option allows employees the same benefits, and more, when it comes to after-tax savings and withdrawals. In fact, the Roth 401(k) has a higher contribution limit than Roth IRAs ($19,500 vs. $6,000) and allows for a company match. 

Roth won’t work with my investments in my 401(k). The Roth vs. pre-tax decision has nothing to do with investments. It is purely a tax decision, and in most 401(k) plans, the money will go into the exact same investments as your pre-tax money does.

While these are some of the top reasons employers cite for not embracing Roth, the fact is, there are times when Roth will be the better option.

The Difference Between Traditional Pre-Tax 401(k) and Roth 401(k) Contributions

The basic difference between traditional pre-tax and Roth 401(k) contributions lies in whether employees want to pay taxes on their earnings or not.

Traditional 401(k): Contributions are made with pre-tax contributions, or in other words, before Uncle Sam rips an employee’s dollar bill in half. They don’t pay the taxes today, but will pay taxes not only on their contributions but also on earnings when they take out the money in retirement.
Roth 401(k): Contributions are made with after-tax contributions, so employees will pay the taxes on their contributions today but take out those contributions and all of the earnings tax-free when they retire.  

The reality is that we don’t know what taxes will look like in the future, so it’s very difficult to make a decision on whether to save before or after taxes based on an unknown. So let’s eliminate the unknown, and just deal with what we do know: we will all pay taxes on the money that we contribute to our 401(k), whether we pay them now or when we retire, so if we assume that taxes will stay the same throughout our working lives, then that amount becomes a wash. The only thing left to consider is the earnings. (James Carville famously advised Bill Clinton in the 1990s prior to a presidential debate that “it’s all about the economy.” Roth 401(k)s are “all about the earnings.”)

There are other things to consider, such as the impact of the tax deduction employees receive in their current paycheck by saving on a pre-tax basis. People with higher incomes may need that deduction today. Also, a Roth 401(k) account needs to be “active” for a minimum of five years. This means that an employee cannot close out the account and withdraw the money during the first five years, or the earnings become taxable. The same applies if they withdraw the money prior to age 59 ½ ; the earnings would become taxable in that case as well.

 

How Do Your Employees Choose Which is the Better Option?

Which retirement option is right for your employees? Here are some guidelines, although there are no black and white answers to this question.

 

Roth 401(k)s are generally a better option for those with:

- A long time before retirement. The more time an employee has for the earnings to grow, the better.
- Lower incomes. If employees are in a lower tax bracket today, they don’t get a large benefit by saving on a pre-tax basis.
- Higher incomes. That’s assuming they are not eligible to save in a Roth IRA and don’t need the tax deduction today.
- The desire to create tax advantages at retirement when determining how much their monthly paycheck in retirement will be.

 

People who are just getting started in their careers generally have a long road ahead of them and are lower on the pay scale, so Roth 401(k)s are often a home run for them.

 

Traditional 401(k)s are generally better for those:

- Who are closer to retirement. These folks may not have enough time for the earnings to compound to make it worth the advantage.
- With higher incomes. This is true assuming they need the tax deduction now.
- With fixed incomes. They may not be able to afford the decrease in take-home pay that would occur by switching to a Roth account as they would lose the tax deduction.

 

For people who don’t exactly fit in either of these camps, or people who have characteristics of both, there is always the option to split the contribution. Choosing a traditional 401(k) or a Roth is not an exclusive decision, and employees may choose to save some in each. As long as they don’t exceed the contribution limit, they can save in each, and may split the contribution in any proportion they choose (i.e., not always 50-50).


There are a lot of different retirement vehicles you can offer your employees, and there is no true “best practices” advice one can give on the matter without a personal consultation. As I said, it’s not black and white, and it’s up to the employee on how they use said vehicles, but this overview should give you a good enough idea of the differences between traditional 401(k)s and Roth 401(k)s to get started. The key is making the feature available, and allowing the employees to make the choice that is best for them.

 

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Jim Sampson is the Director of Retirement Advisory Services at Hilb Group Retirement Services in Warwick, supporting retirement plans for companies and their employees for the last 24 years, and is the co-author of the book Save Like a Champion Today, A Winning Game Plan for Retirement.

 

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