More and more employers are offering a Roth 401(k) as an option for employees to save for retirement, but it’s probably not a good deal for most savers.
A Roth 401(k) allows you to contribute funds in retirement that you pay taxes on today. These funds can grow tax-free, and retirement distributions are also tax-free. With the SECURE 2.0 act, matching contributions may also benefit from Roth treatment.
While the promise of a tax-free retirement might sound great, using a Roth 401(k) could end up costing more than just paying taxes. And you can probably save more using the traditional tax-deferred retirement savings account. Here are two reasons to avoid a Roth 401(k) for your retirement savings.
1. The costs probably don’t outweigh the savings
A regular taxable brokerage account might produce better savings than a Roth 401(k).
The biggest downside to saving in a 401(k) are the fees — 401(k) fees include administration, investment, and service fees, and they can add up quickly. The average 401(k) account pays fees equal to 0.87% of its assets.
While 0.87% may not seem like much, it adds up quickly. Not only do the fees come out every year, but you also lose the possibility of the money spent on fees building up over time.
In comparison, you can choose your own brokerage account and pay close to $0 in fees per year. There are index funds with expense ratios of only a few hundredths of a percent.
Although you will have to pay taxes on your retirement savings upon sale, you will likely be able to keep the tax burden very low. The long-term capital gains tax rate is only 15% for an individual with taxable income above $44,625, or $89,250 for a married couple. Less than that, and you’ll pay 0% tax. There is a 20% tax bracket for very high earners, and you may also owe state and local income tax on the amount.
But if you compare the costs of the average 401(k) fee to the tax on a taxable account, you’ll see that it doesn’t take long for a taxable account to be profitable. After 17 years, you will have lost more than 15% in fees on your initial contribution based on an average fee of 0.87%. And you only pay taxes on your winnings. The main investment comes out tax-free.
If you can manage your capital gains in retirement, you can probably get away with using a taxable account instead of a high-fee Roth 401(k). Not to mention that you will not lock your funds before the age of 59 and a half.
2. A traditional 401(k) probably offers more tax savings
Deducting 401(k) contributions from your taxes today will likely result in more usable savings for you in retirement than if you contributed to a Roth 401(k).
The conundrum is that when you make a tax-deductible contribution to a traditional 401(k), you reduce your tax-adjusted gross income. This means you save on taxes at your marginal tax rate. So if you contribute $10,000 to your retirement account and you’re in the 22% tax bracket, you save $2,200 in taxes. The corollary is that you’ll only be able to put about $8,200 into a Roth account, because you’ll have to set aside an additional $1,800 (22%) for your higher tax bill.
But it’s very likely that you’ll be able to keep your overall tax in retirement below your current marginal tax rate. This is because the United States uses a progressive income tax system. So before you reach the point where you pay 22% tax on every additional dollar you withdraw, you will pay 0%, 10%, and 12% on certain amounts of your withdrawals. Even if you and your spouse completely fill the 22% tax bracket in retirement, your effective federal tax rate will be less than 15%.
A Roth account usually makes sense in extreme cases. When your income is so low that you already pay very little tax and want to lock in your low marginal tax rate, this makes sense. But once your income reaches levels at which your marginal tax rate is higher, it generally makes more sense to choose the tax-deferred account over the Roth account.
Consider the long-term implications of the Roth account
When saving for retirement, it’s important to consider more than just the immediate tax consequences of the type of account you use. You may find that you can save a lot more money for retirement if you use a taxable account or a traditional 401(k) instead when you factor in the impact of fees and paying taxes up front. at your marginal tax rate.