The amount of wealth in 401(k) plans has grown exponentially over the last 20 years. Since 2000, total defined contribution plan assets have nearly quadrupled—from $3.0 trillion to $11.2 trillioni—and many investors now count on them as their main source of funding in retirement.
And as 401(k) plans have proliferated, so has the share of plans that allow employees to contribute after-tax dollars to a Roth account. By the end of 2021, roughly 88% of plans permitted participants to save in a Roth 401(k), according to the Plan Sponsor Council of America.ii Yet only 28% of participants took advantage of the opportunity. Have workers missed the boat? And given the chance, should you contribute on a pretax basis to a traditional 401(k) or steer after-tax dollars into a Roth 401(k)?
New Legislation Heightens the Urgency
The passing of the Secure Act 2.0 legislation in late 2022 makes this question even more pressing. The new law introduces several notable changes impacting Roths, including:
- allowing employers to make matching contributions to an employee’s designated Roth account (Sec 604); importantly, while the Roth or other non‐elective retirement plan contributions are treated as matches, they are not excluded from gross income;
- authorizing SIMPLE and SEP Roth IRAs beginning in 2023 (Sec 601);
- directing “catch‐up contributions” to employer-sponsored retirement plans exclusively into designated Roth accounts for certain high-income earners; this impacts eligible participants whose wages from the employer sponsoring the plan exceed $145,000, indexed for inflation, for the preceding calendar year starting in 2024 (Sec 603).
Note that whether you contribute to a Roth 401(k) vs. traditional 401(k), your investment options remain the same. The difference lies in taxes. With traditional contributions, you receive a pretax deduction, and those assets grow tax-deferred until taken out of the plan. At that point, they become fully taxable at your ordinary income rate. With Roth contributions, you don’t receive a tax deduction. Instead, you pay taxes on the contribution, but all future growth occurs tax free and when you take a qualified distribution,iii your withdrawal remains free of any taxes, too.
Which Works Best?
While it may sound counterinitiative, if you contribute the same amount to a traditional 401(k) on a pre-tax basis—or a Roth 401(k) on an after-tax basis—the ultimate value in dollar terms will be the same, provided there are no withdrawals and each holds the same allocation.iv With that said, all assets are not created equal. Though the value may be the same, the Roth dollars are worth much more. Why? Because those assets can be withdrawn tax-free, whereas the traditional 401(k) dollars have yet to account for taxes and are thus worth substantially less.
Consider a 40-year-old employee choosing between a Roth 401(k) vs. traditional 401(k) for a $20,000 nest egg. We project that each would grow to $1.19 million over 25 years, assuming a mix of 70% stocks and 30% bonds. However, with a traditional 401(k), the participant receives a $20,000 tax deduction—which means paying $8,000 less in taxes each year, assuming an effective tax rate of 40%.
If you were savvy enough to put this $8,000 to work in a taxable brokerage account, those funds would grow to $410,000 over the same period, according to our projections. At this point, contributing on a pretax basis to the 401(k) would yield more “total” wealth on paper. Essentially, while the amounts in your traditional and Roth 401(k) remain the same, you have accumulated an additional $410,000 in a separate taxable portfolio (Display).
On the other hand, the $1.19 million in your traditional 401(k) is fully taxable, resulting in an after-tax value of $714,000 (applying the same 40% rate). Adding the after-tax value of $714,000 to the $410,000 in the taxable portfolio results in total wealth of $1.12 million by going the traditional 401(k) route. That’s considerably less than the $1.19 million in your Roth 401(k). How could this be? Well, the money that was “saved” in a taxable portfolio benefits from more favorable tax rates. But at the same time, those assets are subject to taxes every year on the interest, dividends, and realized capital gains. Compare that to the assets in the Roth 401k, which are all fully income-tax free.
Of course, few investors liquidate their entire 401(k) all at once. So, let’s extend our analysis of the Roth 401(k) vs. traditional 401(k) over 35 and 45 years. Here you can see the benefit of the Roth continues to grow. After 45 years, the Roth ends up with $620,000 or 17% more wealth than a traditional 401(k) contribution on an after-tax basis (Display).
Think of the taxes on a Roth contribution as additional “forced savings.” Sure, that $8,000 could be saved in a taxable brokerage account—but not without having annual taxes levied on interest, dividends, and realized capital gains. In contrast, if you pay the taxes on the $8,000 Roth contribution, you free up more assets to compound tax-free for many decades. For investors who tend to divert extra cash into lifestyle spending, the case for contributing to a Roth becomes even more powerful.
Lower Tax Rate in Retirement?
Clearly, the longer the Roth grows tax-free, the bigger the benefit it ultimately provides. But what if your tax rate declines once you stop working? To answer this, let’s revisit our Roth 401(k) vs. traditional 401(k) example, but assume the effective tax rate in retirement drops to 30% (i.e., 10% less).
In short, the Roth still comes out ahead (Display). After 45 years, the Roth ends up worth $200,000 more, or 5%, on an after-tax basis. For the traditional 401(k) to equal the Roth on an after-tax basis over that same period, the tax rate would need to fall by ~14%, according to our estimates. However, here the investment horizon plays an outsized role. Put simply, the longer the Roth dollars grow, the larger the retirement tax rate can decline, and the Roth will still come out ahead. Conversely, the shorter the investment period, the more susceptible the result will be to the ultimate retirement tax rate.
The choice between a Roth 401(k) vs. traditional 401(k) involves many factors—and you can always split between the two, provided the total amount does not exceed IRS contribution limits. As you weigh your options, consider the following:
- Time Horizon: The longer the dollars stay in the Roth, the bigger the benefit Roth contributions provide.
- Tax Rate: If your tax rate will not substantially decline in retirement, the decision favors a Roth. The same holds true if your tax rate is lower now than it will be in the future. Conversely, if you expect your tax rate to fall substantially, the decision favors a traditional 401(k) contribution.
- Savings Power: If you’re likelier to spend than save, the Roth’s “forced savings” option might appeal to you. But what if you have the wherewithal to save more than allowed? Here, a Roth also shines. Sheltering $22,500 in a Roth 401(k) would be equivalent to saving $35,700 in a traditional 401(k)—that’s above the IRS limit.
- Cash Flow: Some rely on their tax deduction to meet other spending requirements, so reviewing your cash flow needs can also help you determine which route to pursue.
- State of Residence: Will the state you plan to retire in have a lower tax rate than where you currently reside? High income tax states like California are subject to a top rate of 13.3%. Those who relocate to a state with no income tax (e.g., Tennessee, Florida, Nevada, etc.) can plan to receive an immediate tax cut.
The changes ushered in by the Secure Act 2.0 will prompt many investors to take a second look at contributing to their Roth accounts. If you’re choosing between a Roth 401(k) vs. traditional 401(k), your Bernstein advisor can help you determine the best strategy based on your individual circumstances.
- Andrew Bishop, CFA
- Director—Wealth Strategies Group
i Through December 31, 2021. Source: https://www.ici.org/statistical-report/ret_22_q3#:~:text=Assets%20in%20individual%20retirement%20accounts,percent%20from%20June%2030%2C%202022
iii A qualified tax-free distribution is any payment or distributions from your Roth IRA that is made after the 5-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for your benefit, and (i) made on or after the date you reach age 59½, (ii) made because you are disabled, (iii) made to a beneficiary or to your estate after your death, or (iv) one that meets the requirements listed under First home under Exemptions in chapter 1 (up to a $10,000 lifetime limit). Source: IRS Publication 590-B.
iv The same applies to SEP IRA/SEP Roth IRA.