Roth vs. traditional 401(k)s: What to consider for clients

Should an investor make Roth deferrals or traditional, pretax contributions into a 401(k) plan? It’s a question that could have large tax implications for clients.
The answer, at its most macro level, boils down to a client’s current tax bracket versus what that investor’s tax bracket may be in retirement.
“The dominant factor in choosing Roth versus traditional is tax rates,” said Daniel Moisand, financial planner at Moisand Fitzgerald Tamayo. “We’ll recommend people use the Roth rather than the traditional when we believe their future tax rate will be higher than their current tax rate.”
According to the Plan Sponsor Council of America, nearly 58% of 401(k) plans allowed for Roth deferrals in 2014, up from 51.6% the year prior. Despite the broader availability, participants didn’t seem to take advantage — only 19% of them made Roth deferrals in 2014, essentially no change from 2013.
Roth is particularly valuable for young, lower-salaried individuals or couples in a low tax bracket who think they’ll probably have higher earnings down the road, Mr. Moisand said. In that scenario, paying taxes upfront while in a lower bracket would yield less tax payout than deferring a tax hit to retirement when in a higher bracket.

Most people expect to be in a lower tax bracket in retirement, though, which would make pretax 401(k) deferrals more preferable, Mr. Moisand said. After all, there’s a reason for a 70% to 80% income-replacement ratio being widely touted as a sound retirement savings goal.
However, there are several variables that should go into weighing the best decision for clients, according to Carolyn McClanahan, director of financial planning at Life Planning Partners Inc. She considers age, current and future tax status, and overall tax diversification between traditional, Roth and taxable accounts.
“You have to understand what the client’s needs are first, then you apply the hierarchy,” Ms. McClanahan said.
For example, Roth 401(k) contributions could prove a useful estate-planning tool. One of Ms. McClanahan’s clients is a wealthy business owner making a $500,000 annual income, which would, on the surface, indicate pretax deferrals make more sense — he’d get a tax break now on what would be a hefty tax bill due to his being in the highest bracket. But the client wants to leave this pot of retirement money for his daughter, and so invests using Roth to maximize the money she’ll inherit.
On the flip side, for a wealthy client who doesn’t have these sorts of long-term goals and wants to free up cash flow in the near term, the traditional route probably makes most sense, Ms. McClanahan said.
Erik Carter, financial planner at Financial Finesse Inc., thinks the majority of people are better off investing in a traditional 401(k) if they expect to be in a lower tax bracket in retirement or if they expect to be in the same bracket.
That’s because clients end up paying a lower effective tax rate if they remain in the same bracket, Mr. Carter said. That’s due to the incremental way income tax is assessed.
Let’s take the example of a client with a taxable income of $40,000: Roughly the first $10,000 is taxed at a 10% rate; then, the rest up to $37,650 is taxed at 15%; income over that is taxed at 25%, meaning around $3,000 in this scenario would be taxed at 25%.
Roth dollars would be taxed at 25% in this example, because it would have come off the top of income. But the bulk of traditional 401(k) money would be assessed at 15% when in retirement and those distributions are taken as income. (Remember, money up to $37,650 is taxed at 10% to 15%.)
So, in short, it boils down to an approximately 10-percentage-point savings on the tax rate, Mr. Carter said.
Traditional could also be better for a client looking to hit a company match level while freeing up as much cash as possible, according to Andrew Sivertsen, part owner of The Planning Center Inc.
“It’s less net dollars they’re taking to get to the match,” Mr. Sivertsen said.
Roth could represent a better deal, though, for an investor maxing out a 401(k), because $18,000 in an after-tax Roth account is more valuable than $18,000 in a pretax traditional account. Eighteen thousand dollars is the contribution limit for 2016, with the possibility of a $6,000 catch-up contribution.
ROTH 401(k) vs. IRA
Of course, aside from investing in a 401(k), advisers could also direct clients to a Roth IRA. But there are some nuances advisers should note.
There aren’t any income limits to invest in a Roth 401(k), whereas there are for Roth IRAs. For example, the limit for married couples is an adjusted gross income of $184,000, with a phase-out range between $184,000 and $194,000. The limit for singles is $117,000, with a phase-out range between $117,000 and $132,000. Contribution limits for Roth IRAs are $5,500, with an additional $1,000 catch-up available, which is much lower than for 401(k) plans.
However, Roth 401(k) investors must take required minimum distributions at age 70 1/2, unless they’re still working for the employer offering the 401(k). Roth IRA investors don’t need to take RMDs.