Clients with access to a 401(k) plan either through their workplace, or via a Solo 401(k) if self-employed, generally seek your advice regarding how to invest their money inside the plan. Another decision on which they may seek your advice is whether to contribute to a Roth account within their 401(k) if one is offered or to a traditional 401(k) option.
Here are some things to consider in advising them on this issue.
Taxes Now or Later?
As you know, contributions to a Roth account are made with after-tax dollars. If various rules, including the 5-year rule are followed, withdrawals can be made tax-free in retirement.
Contributions to a traditional 401(k) account are made with pre-tax dollars, offering a tax-break now and deferring the taxes on the contribution plus any earnings in the account until they are withdrawn in retirement. At that point withdrawals are taxed as ordinary income.
Part of your advice to your client will depend upon your client’s current tax situation, as well as their anticipated tax situation in retirement. For high-earning clients is the tax break today worth more than the potential value of tax-free withdrawals at some point down the road in retirement?
For clients whose retirement investing has been heavily concentrated in traditional IRA and 401(k) accounts, a Roth 401(k) can provide tax diversification for their retirement accounts.
Nobody knows where income tax rates will head in the future. Having retirement assets in both traditional and Roth accounts can help clients hedge their tax bets for retirement.
This tax diversification can offer a number of planning opportunities for clients as they approach retirement.
Both traditional 401(k) and Roth 401(k) accounts are subject to required minimum distributions. However, if a Roth 401(k) account is rolled over to a Roth IRA when your client leaves their employer, the money rolled over will receive the same treatment as other funds in a Roth IRA and will not be subject to RMD requirements.
Roth IRAs left to a spousal beneficiary upon the account holder’s death continue this exemption from the need to take RMDs. Non-spousal beneficiaries can generally make account withdrawals free of taxes as required.
RMD planning can have implications both for client’s retirement income planning as well as their estate planning in terms of leaving IRA accounts to their desired beneficiaries.
With the new rules contained in the SECURE Act as far as changes to the rules for inherited IRAs for non-spousal beneficiaries, the use of a Roth 401(k) account as a means to ultimately contribute higher amounts to a Roth account that can ultimately be rolled over to a Roth IRA is a very viable planning tool in this new environment.
Higher Roth Limits
For those clients who want to contribute to a Roth account, but whose income prohibits them from doing so with a Roth IRA, the Roth 401(k) can provide a solution. Roth 401(k) contributions do not have an income restriction, the only limits are contribution limits on a 401(k) for the current year. In 2020 these are $19,500, with an additional catch-up of $6,500 of those who are 50 or over at any point during the year.
Contributing to a Roth 401(k) may be a good alternative to tactics such as a backdoor Roth or even a Mega Backdoor Roth strategy for those who want to accelerate the amount that ultimately ends up in their Roth IRA account. At the very least, contributing to a Roth 401(k) can complement your client’s efforts through these other tactics to ultimately build a substantial balance in the Roth IRA account.
For self-employed clients, a Solo 401(k) can provide a retirement savings option that allows the full amount of employee contributions as a regular employer sponsored plan, plus options for substantial profit-sharing contributions as well. Many custodians offer a Roth option for Solo 401(k)s and the bulk of the points made previously apply here as well.
Note that the employer profit-sharing contributions must be made to a traditional 401(k) account.
Why Not Both?
Whether to contribute to a Roth or traditional 401(k) option does not have to be an either-or decision for your clients. Contributions can be made to both types of options within their 401(k) plan up to the 401(k) contribution limits for the year. The decision can also be alternated from year-to-year. If a Roth 401(k) makes sense in one year, but the client’s situation evolves to where contributions to the traditional 401(k) option makes more sense, then it's both fine and generally easy to make this switch.
The ability to contribute to either a Roth 401(k) or a traditional 401(k) account offers planning options for your clients. This is another area where you can help them make the best decision for their situation and add value as an adviser.