Your client asks you for guidance on their 401(k) contributions. Beyond which plan investment options to choose, they want to know whether or not to contribute to the Roth option in their plan, or stick with the traditional option. Here are important factors to consider in answering their questions and guiding their decision.
Their Tax Situation
A key factor in your answer will depend upon your client’s tax situation. If they are high-earners, the tax benefits of making pre-tax contributions now might outweigh the benefits of tax-free withdrawals down the road in retirement.
On the other hand, clients whose retirement savings are largely in traditional 401(k) and IRA accounts might benefit from contributing to a Roth 401(k), explains Walter DuPre, CFA and partner with Buckhead Capital Management. ”None of us can be sure that future tax rates won’t be higher than today, so having some retirement assets in a Roth 401(k) provides tax diversification as they begin to make withdrawals,” DePre says.
If you are fairly certain that a client will be in a lower tax bracket in retirement, this might favor contributions to a traditional 401(k) to receive the benefits of pre-tax contributions now. If it seems possible that your client might be in the same or even a higher tax bracket in retirement, then the Roth 401(k) might be the better option. For example, this situation could arise if your client will be eligible to receive substantial pension payments from their current or a former job.
Echo Huang, CFA, CFP, CPA of Echo Wealth Management stresses the need for advisors to remind their clients of the importance of considering their marginal tax rate versus their average tax rate when making this decision.
Required Minimum Distributions
One of the major benefits of a Roth IRA is that these accounts are not subject to required minimum distributions (RMDs) at age 72. While a Roth 401(k) account would be subject to RMDs, rolling it over to a Roth IRA would allow your client to avoid RMDs. The ability to avoid RMDs in Roth IRAs makes them a powerful estate and retirement planning tool for many clients.
No Income Limits
According to Brendon Renfro, PhD, CFP, a 401(k) is a great way to save Roth dollars because there are no income limitations on Roth 401(k) contributions as there are with Roth IRAs. Additionally, clients can contribute up to the full salary deferral amount allowed in a year versus the lower contribution limits with a Roth IRA. For those clients who want to contribute to a Roth account, a Roth 401(k) offers a solid option.
Contributing to both a traditional and a Roth 401(k) account might be a good choice for most clients. While any employer matching contributions must go into a traditional 401(k) account, the employee’s contributions can be split between the two in any proportion desired up to the annual contribution limits in effect at the time for a 401(k) plan.
Much has been written about the benefits of Roth accounts, creating a prime opportunity for you to guide your clients, who may be conflicted in deciding which type of account is best for their 401(k) contributions.