Since Roth contributions made their debut in 401(k) plans back in 2006, families have mostly been left on their own to figure out whether they should make pre-tax 401(k) contributions or Roth 401(k) contributions. The allure of Roth is that savers bank on the tax rates increasing in the future and the tax-free growth yielding more income in the future than tax-deferred savings would with traditional pre-tax 401(k) deposits. Some savers see Roth deferrals as a tax hedge since employer contributions to a 401(k) are tax-deferred. With the Consolidated Appropriations Act of 2023, including SECURE 2.0 provisions, being passed by Congress last week the determination of whether to elect Roth will take on an even more crucial role as there are several provisions in the proposed bill that will expand Roth utilization inside of 401(k) plans.
Aggressive Rothification of Qualified Plans
The newly passed SECURE 2.0 package has several provisions designed to cause more deposits to be Roth contributions. Savers should pay attention to the new Roth provisions being included in Title VI of SECURE 2.0, titled 'Revenue Provisions'. Specifically, the bill provides for:
SEP & SIMPLE IRAs to allow for Roth contributions, effective in 2023;
Catch-up contributions deemed Roth for savers with prior year wages over $145,000 (indexed to inflation), effective for plan years beginning after 12/31/23; and
Savers ability to elect to have match and non-elective employer contributions treated as Roth, effective immediately on enactment.
Why the push? Simple, it's a revenue raiser for Treasury. For many working families, Roth contributions can be expected to reduce your retirement readiness but many believe the opposite is true. Let's look at the real picture.
The Roth Reality
In reality, determining whether Roth is advantageous for you is complex and quite personal. There is no easy way to determine what's right for you. The determination must account for all of your financial circumstances today and your expected future circumstances, many of which are difficult to project.
Many families determine savings amounts based on their monthly budgets. If they can save $100 per paycheck, that would equate to a $100 Roth deposit or a pre-tax deferral of more than $100, since no taxes are due on the pre-tax deposit, so many families save more on a pre-tax basis than they would with Roth. Assuming the accounts are invested identically, the pre-tax account balance will experience more growth (in dollars) due to the higher deposited amount. This compounding is significant as the expected difference in earnings growth would need to be less than the expected tax on the pre-tax account distribution for Roth to be advantageous to a saver.
There is some guesswork necessary projecting future tax rates. Current tax rates are lower than they have been historically but most of the drastic changes in tax rates come into play with the highest income levels, not the average households. While the tax rates fluctuate regularly, the rates tend to stay pretty consistent for average income households. The other consideration is that many retirees will have a lower effective tax rate in retirement than they do while they work, as they only withdraw what they need and generally have lower income needs.
Who Benefits From Roth?
Roth isn't for everybody, but where it works, it tends to work really well. Young workers with lower wages should take advantage of Roth contributions. The combination of their low effective tax rate and decades of tax-free earnings growth make this an easy decision for many young workers. With many students making around $15/hour in part time jobs, Roth can be a great option for saving for college too, as there is no minimum age for a Roth IRA and distributions avoid the early withdrawal penalty if used for college expenses. Roth also can make sense for high wage earners that aren't constrained by a monthly budget since making a $100 Roth contribution will almost certainly yield more retirement income than a $100 pre-tax contribution and provides some tax planning opportunities in retirement that could also be helpful, but it's important to realize that that's not an apples-to-apples comparison. For everyone else, it depends.
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