When it comes to planning for retirement, many investors turn to Roth 401(k)s for their tax advantages. These accounts allow individuals to contribute after-tax dollars, and any qualified withdrawals in retirement are tax-free. While the Roth 401(k) is a powerful tool for building a tax-free nest egg, the choice of investments within the account plays a crucial role. One popular investment option that often serves as the default, the target date fund, may not be a tax-efficient choice for those seeking optimal returns. In this blog, we'll explore the tax inefficiencies associated with relying solely on target date funds in a Roth 401(k).
Understanding Target Date Funds:
Target date funds are investment vehicles designed to automatically adjust their asset allocation based on an investor's expected retirement date. The idea is that as the investor approaches retirement, the fund gradually shifts from a more aggressive to a more conservative allocation. While these funds offer a hands-off approach, they may not be the most tax-efficient option within a Roth 401(k).
Where You Invest Matters
Most investors making Roth 401(k) contributions also receive pre-tax matching (and maybe even profit sharing) contributions. Since the pre-tax money will be taxed when it's withdrawn and the Roth shouldn't, it makes a lot of sense to try and skew your overall account to maximize the growth in your Roth bucket by overweighting your Roth investments in growth oriented investments while using tax-deferred money to balance out your risk with more income oriented choices. Totally confused?
Let's look at an example
Patty is 40 years old and plans to retire in the year 2040. Her account is 50% Roth and 50% Employer Match and her employer matches her contributions dollar for dollar. She invests her entire account in a 2040 target date fund, which currently invests 80% in stocks and 20% in bonds. Since the Roth is invested the same way as the pre-tax, she can expect both sides to grow at the same rate until she retires.
Patty could invest 100% of her Roth in stocks and invest her pre-tax money 60% in stocks and 40% in bonds without changing her overall risk - she still has 80% of her overall account in stocks - but with this change the tax-free Roth account would be expected to grow more than the pre-tax match, so Patty would have more of here account distributed tax-free when she retires.
Why it Matters
Target date funds account have steadily increased in market share of retirement plan assets since their inception, often serving as the default investment in a plan. Most investors don't understand the impact than this can have. Participants using target date funds across Roth and pre-tax investments may lose out with tax efficiencies, which could have a significant impact over several decades. This is a cost that you'll never see on a statement and you may never realize you've incurred, but one that's easy to avoid with a little planning!