PUBLISHED: | UPDATED:

The traditional 401(k) plan is one of the most popular retirement plans around. Since 1981, when it first became an alternative to defined benefit pensions, the 401(k) has grown to become the most popular retirement savings vehicle. About 90% of employers offer a 401(k). More than 58 million people have one, and they hold a collective $6.2 trillion as of Dec. 31, 2019, according to the Investment Company Institute.

The Roth 401(k), as the name implies, is a combination of the Roth IRA and the traditional 401(k). The Roth 401(k) first became available in 2006. In the 13 years since Roth 401(k)’s were launched, these accounts have become more common in most retirement plans. About 70% of employers offer a 401(k) plan. However, many individuals have largely ignored their Roth 401k accounts. A recent study by the Plan Sponsor Council of America found that less that 20% of participants who have access to a Roth 401(k) make contributions to them.

One question I am often asked at investment seminars or when meeting with a potential new client is: “If I had to choose between saving only in a Roth 401(k) or traditional 401(k), which would I choose?”

Let’s first discuss some of the features, similarities and differences between the two plans.

Contribution limits

The Roth 401(k) and traditional 401(k) have the same annual contribution limits. In 2020, you can contribute up to $19,500 a year (or $26,000 if you’re 50 or older). Unlike the Roth IRA, the Roth 401(k) has no annual income restrictions or limitations. Anyone at any income level can contribute.

Taxes

The big difference between a traditional 401(k) and a Roth 401(k) is when you pay the taxes. With a traditional 401(k), you make contributions with pre-tax dollars, so you get a tax break upfront, helping to lower your current income-tax bill. Your savings (both contributions and earnings) grow tax-deferred. When you retire and begin withdrawing money from your account, every dollar withdrawn is taxed as ordinary income. With a Roth 401(k), it’s basically the reverse. You make your contributions with after-tax dollars, meaning there’s no upfront tax deduction. However, withdrawals of both contributions and earnings are tax-free in retirement.

Required minimum distributions

Just like traditional 401(k) accounts, Roth 401(k) accounts are also subject to required minimum distributions once the investor reaches age 70½ (age 72½ for those born on or after July 1, 1949). However, individuals with a Roth 401(k) can avoid taking RMDs by converting it to a Roth IRA. to do this, there is, however, a five-year rule that needs to be met.

Social Security/Medicare

Withdrawals from 401(k) plans are considered taxable income in the year you take them. This increase in income can impact the taxation of Social Security benefits and the amount of your Medicare Part B premiums. Roth 401(k) distributions are tax-free and are excluded from the formulas that determine Medicare Part B premiums or how much tax is owed on Social Security benefits.

Beneficiaries

With a Traditional 401(k), non-spousal beneficiaries (i.e., children and grandchildren) are subject to taking required minimum distributions and are taxed on those distributions. With a Roth 401(k), non-spousal beneficiaries are also subject to taking RMDs but are not taxed on those distributions

And the winner is …

When it comes to choosing between saving in a traditional 401(k) or a Roth 401(k), my vote goes to the Roth 401(k).

The conventional approach for deciding between saving in a Roth 401(k) or a traditional 401(k) is based almost entirely on one question: What do you think your federal tax rate will be in retirement? If you think your tax rate will be lower in your retirement years than it is now, then you should be saving in a traditional 401(k). If you think your tax rate will be higher in your retirement years, then you should be saving in a Roth 401(k).

There are two problems with this approach. The first is that no one knows what tax bracket they will be in on the day they retire. Even if your tax rate is lower in the year you retire, it is possible that tax rates could rise in the future. And instead of working the tax system to your advantage by deferring taxes at a high rate during your working years and paying them at a lower one, you could end up doing just the opposite.

When it comes to paying taxes in retirement, there is, however, one thing we do know: Every dollar withdrawn from a traditional 401(k) in retirement will be taxed. With a Roth 401(k), we know that every dollar of contributions, interest, dividends and capital gains withdrawn during retirement will be tax-free. We know exactly what our tax rate will be during our retirement — 0%.

With a Roth 401(k), you essentially get your tax obligations to Uncle Sam out of the way during your working years and enjoy the tax-free earnings during your retirement years. And I would rather pay my taxes now, when I know what my tax rate is, while I am employed and earning a paycheck, rather than paying an unknown tax rate when I am retired, and the paychecks have stopped.

Martin Krikorian is president of Capital Wealth Management, a registered investment adviser investment management services, at 9 Billerica Road, Chelmsford. He can be reached at 978-244-9254, www.capitalwealthmngt.com, or via email at info@capitalwealthmngt.com.