According to an old adage, it's better to tax the seed than the crop. And if you're comparing traditional retirement accounts with Roth retirement accounts, this seems to ring true.
With traditional retirement accounts, the contributions (i.e., the seeds) are tax-deductible, reducing your client's income tax burden today. These contributions grow tax-free until your client needs access to the account; that's when he or she incurs taxes on a much larger crop. Roth retirement accounts, on the other hand, offer no up-front tax benefits, but withdrawals from Roth accounts are tax free. In fact, these accounts are designed to help clients escape future taxes on the crop.
So what's the best retirement plan fit for your clients? Here, we'll:
- Evaluate traditional and Roth retirement accounts
- Compare Roth IRAs versus Roth 401(k)s, if a Roth is determined to be the right choice
Traditional Versus Roth Retirement Accounts
As I stated above, traditional retirement accounts are intended to help individuals defer taxes until retirement; Roth accounts are designed to help them avoid paying taxes in the future. And unlike traditional retirement plans, there is no requirement to withdraw money from a Roth account until desired.
If you anticipate that your client's marginal tax bracket will be substantially lower during his or her retirement, years of tax deferral through a traditional retirement account may offset that future tax bill. On the other hand, if you expect tax rates to rise in the future, your client may be wise to consider putting some funds into a Roth account, which offers more options for tax savings.
Not everyone is eligible to contribute to a Roth account. As an individual saver, you may be subject to earned income limits. But Roth retirement accounts available through an employer's 401(k) or 403(b) plans aren't subject to these limits, and individuals can generally contribute more to them than to an individual Roth IRA.
Roth IRAs Versus Roth 401(k)s
The kind of Roth account that your client chooses should depend on several factors:
Individual contributions. There is a combined cap on how much an individual can contribute to Roth 401(k) and traditional 401(k) accounts. Contributions to one will affect the other, but workers are never ineligible because their salary is too high. Plus, the cap on a Roth 401(k) is much higher than on an individual Roth IRA.
With an individual Roth IRA, workers may not be eligible to make contributions in a year when their income is over the limit. If they are under the limit, they can contribute both to a Roth 401(k) and an individual Roth IRA.
Employer contributions. To encourage participation in company retirement plans, many employers match all or a percentage of employee contributions to their Roth 401(k)s. Even if the employer match is subject to a vesting schedule, encourage clients to aim to contribute enough to maximize the match.
Choice of investments. Often, employer-sponsored Roth 401(k)s offer access to investment managers not available to individual investors and without the sales charges that one might incur when investing in an individual Roth IRA. Employers, however, may limit these investment choices. If the available options won't help your client reach his or her retirement goals, a good option is to have your client supplement his or her portfolio with nonqualified and individual Roth IRA savings.
Level of expenses. Although most employer-sponsored Roth 401(k) plans are low cost, don't assume that there are no expenses. HR departments don't always supply up-to-date materials on the available plans, so advise your clients not to rely solely on company literature to research choices. Instead, invite your clients to reach out to you for an accurate picture of the plan's options, so you can help them make a better decision.
Getting a handle on expenses for individual IRAs is easier. Between fee-based brokerage accounts, low-cost or no-load mutual funds, and other possibilities, there is a wide variety from which to choose.
Distributions. Both Roth 401(k)s and individual Roth IRAs are meant to be left untouched until retirement; however, clients do have the option to take a withdrawal from a Roth IRA at any time. Withdrawals from Roth 401(k)s, like those from traditional 401(k)s, are subject to restrictions while the client is employed. But some plans have hardship provisions, and others permit loans up to certain limits.
So Who Benefits from a Roth 401(K)?
Younger employees who have a longer retirement horizon will have more time to accumulate tax-free earnings in a Roth 401(k) account. And some high-salaried employees will appreciate having both tax-deferred and tax-free money to fund retirement. Employees who want their retirement accounts to pass income tax-free to their heirs may also be attracted to a Roth 401(k).
Are your clients interested in Roth accounts? We'd love to hear your experiences in helping them weigh the pros and cons of Roth IRAs versus Roth 401(k)s. Comment below!