Comparing 401(k) Contributions in 2020 and 2021
In this article, we're going to discuss the three options many employees have with respect to their 401(k) contributions: before-tax, after-tax, and now the Roth 401(k). Back in 2006, many plan administrators took advantage of the new Roth 401(k), and started offering this choice to their company's participants. Let's take a closer look at the difference this new option can make to everyone's retirement funding plans.
Choosing the Right 401(k) Contribution
Employees always had the choice to make before-tax and after-tax contributions to a 401(k) plan. But today, more and more plan administrators have added the Roth 401(k) to the mix. If anyone's receiving matching funds from their employer, then chances are nothing will change if they decide to start funding the Roth. The company will continue to match Roth contributions too. But that doesn't help answer the larger question: Which 401(k) contribution option should I choose?
Employees have three choices when it comes to funding their 401(k) plan: before-tax, after-tax, and Roth 401(k) contributions. Let's take a quick look at the advantages and disadvantages of each before making direct comparisons.
Making a before-tax contribution provides employees with a benefit today by reducing their taxable income. When making this type of contribution, they're able to place more money into their plan, while minimizing the impact on take home pay. This option leaves them with more money in their paycheck.
On the down side, at the time of withdrawal, both the earnings and contributions will be subject to federal income taxes.
If a plan's participant makes after-tax contributions to their 401(k) plan, they're not reducing taxable income now. But when the money is withdrawn, they only have to pay income taxes on the earnings in the account. With this type of contribution, the plan usually allows additional flexibility when accessing the funds before age 59 1/2.
Roth 401(k) Contributions
With a Roth 401(k), the accountholder is contributing on an after-tax basis, but if they hold the account for at least five years, and reach age 59 1/2, the earnings on contributions are not taxed at the time of withdrawal.
Any matching funds provided by an employer, and the earnings on that match, are subject to federal income taxes when they are withdrawn.
The following table shows a side-by-side comparison, summarizing the three options everyone has when it comes to funding their 401(k) plan:
401(k) Contributions Comparison
* Note: Account must be held for at least five years, employee must be at least 59 1/2, deceased or disabled.
Choosing Between Options
There are two important factors to consider before deciding if making before-tax, after-tax, or Roth contributions to a 401(k) account is the best choice:
- Expected Future Income Tax Rate
- Expected Future Return on Investment
Unfortunately, part of this decision is going to be based on a relatively unscientific best guess. But the following is some of the information to consider.
Income Tax Rate
Perhaps the single most important deciding factor has to do with the income tax bracket the accountholder expects to be in when making withdrawals during their retirement years. If they believe they'll be in a higher income tax bracket when retired, then funding a Roth 401(k) has an advantage because they're paying taxes now, while the rate is lower.On the other hand, if they think they'll be in a lower tax bracket in retirement, then making before-tax contributions to a 401(k) has an advantage. That's because they're not paying taxes now, but will during their retirement years when they're expecting the income tax rate to be lower.
Return on Investment
The other questions to think about are the expected return on investment as well as when to start withdrawing money from a 401(k) account. Here's why.
The higher the return on an investment, and the longer someone can go without touching the money in their account, the higher the proportion of earnings they'll have in the account (relative to the money placed into the account).
If someone expects to have a high proportion of earnings in their account, they might be better off making Roth contributions to a 401(k). That's because Roth 401(k)s allow for contributions on an after-tax basis, but the earnings (remember the assumption here is that earnings are a larger proportion of the total account balance) are withdrawn tax-free.
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