If you want your retirement savings to grow tax free, you need a Roth IRA or Roth 401k. But don’t get too hung up on the phrase tax free growth. Roth IRAs and Roth 401k’s are not for everyone, and tax deferral today (non-Roth investments) might be the better answer as alluded to earlier (see Tax Savings and Tax Deferrals). Let’s back up the truck a bit and chat about the Roth tag on an IRA or 401k. And Yes, a Roth IRA is different than a Roth 401k. The words have dramatically different meanings.
The 401k and traditional IRA came about because it was theorized that you had a much higher marginal tax rate during your wage earning years than you would during retirement. For example, you could easily be in the 22% marginal bracket when you are 55, but be in the 12% bracket when you are 70. So, you would save taxes at 22% and pay them back at 10%. Not bad. This theory still holds true for hundreds of thousands of Americans but there have been some recent hiccups.
The data were shifting, and suggested that the delta between wage earning marginal tax rate and retirement marginal tax rate was waning. So, some smart people got together and passed laws allowing the Roth IRA. Specifically it was Senator William Roth from Delaware in 1997 who passed the legislation. Thankfully not much was going on in Delaware in the 90s and Senator Roth was able to create this excellent legislation. As you might be aware, the Roth IRA allows you to take after-tax dollars and invest it, and when you take the money out all of it is tax-free. Beauty!
So, the Roth IRA is not a tax deferral system like a traditional IRA. It is a pay tax now and avoid paying tax later system. But all that glitters is not gold as Robert Plant would say. A Roth IRA is only available to those who earn less than $203,000 per year for married filing joint taxpayers ($137,000 for single taxpayers) for the 2019 tax year, and a Roth IRA has very low contribution limits of $6,000 (2019). Yuck. Now what?
Enter the Roth 401k which is a hybrid of a 401k and a Roth IRA, and can be a great selection among the small business retirement options. All the taste of a Roth IRA without the calories. Starting January 2006, many businesses amended their 401k plans and started introducing Roth options. So, even if your small business doesn’t adopt a 401k plan, your spouse’s job or your main job might benefit from the Roth 401k. Ask your benefits administrator to see if your other job or your spouse’s other job offers the Roth 401k option.
A Roth 401k has no income limitations and employees (you) can defer up to $19,000 (2019) or $25,000 with catchup. But business contributions cannot be designated as Roth. Since the business (employer) matching or profit-sharing is a deduction to the business, these funds are considered pre-tax and will not enjoy tax free growth. In other words, your contributions as an employee may be designated as after-tax or Roth type contributions, and the business’s contribution will be automatically designated as pre-tax or traditional type contributions.
In essence, the Roth 401k has two accounts which can be managed separately with the plan; one after-tax and another pre-tax.
Since the biggest challenge in deciding on using a Roth IRA or Roth 401k pivots on your marginal tax rate during retirement, and crystal balls don’t have the accuracy they used to, a good plan is to hedge against both. A Roth 401k has this feature built-in. Your deferrals as an employee can be Roth (post-tax) which hedge against retirement tax rates being similar to wage earning tax rates. Conversely, business funds are traditional (pre-tax) and hedge against retirement tax rates being lower than wage earning tax rates. Got it? How about this-
The mix between the two is the challenging part. 80% Roth and 20% pre-tax? 60-40%? Truly depends on your vision of retirement and your income sources. Bunch of rental income and residual earned income? Rich parents leaving you with thousands of dollars in dividend income? Gotta coin? Two out of three? As mentioned earlier, financial planning and tax projections are the starting point for an answer that will unfortunately take a lifetime to validate. We can see your head stone now- “Her tax projections hit a 95% confidence interval. Kids are proud.” Small font or big stone. You decide.
So be careful of anyone telling you to always max out your Roth contributions without at least asking questions. And Yes, there are zillions of calculators available on the internet- simply search for “ira versus roth ira calculator” and the inundation will be overwhelming. Or perhaps underwhelming.
Historically Roth options on a 401k plan used to be costly, but thanks to Adam Smith and his concept of economics, fierce competition has driven the pricing down. Down to zero, just ask e*Trade, Scottrade, TD Ameritrade, or any other trade that comes to mind.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition