Many employer plans now contain both a regular 401(k) plan and a Roth 401(k) option. The regular 401(k) allows an employee to defer up to $18,000 of compensation in 2017 ($24,000 for folks age 50 or older) before taxes. The benefit of regular contributions is that you reduce your taxes at the time of contribution, allow the earnings in the plan to compound over time, and defer taxes until you withdraw funds during retirement, when you will possibly be taxed at a lower rate.
Contributions to a Roth 401(k) are made after-tax, i.e., contributions do not reduce your taxable income/taxes at the time of contribution. Earnings also compound over time, but you will not owe tax when you withdraw funds during retirement.
The choice between making regular or Roth 401(k) contributions depends on two primary factors:
- Your relative tax rate at contribution vs. withdrawal
- The number of years in between
Higher future tax rates and longer holding periods favor Roth contributions. Higher current tax rates and shorter holding periods favor regular 401(k) contributions.
Regardless of whether regular or Roth 401(k) contributions are best for you, some employers offer a way to save even more in retirement plans: After-tax 401(k) contributions. Ideally, the contributions are made in addition to regular and Roth 401(k) contributions. After-tax contributions have much higher contribution limits: total plan contributions are capped at the lesser of 100% of compensation or $53,000 ($59,000 for age 50 and older). For example, an employee age 50 or older who is contributing $24,000 to a 401(k) plan and receiving a $6,000 employer match could contribute another $29,000 of after-tax contributions to the 401(k) plan.
Although some plans have allowed after-tax contributions in the past, an IRS notice issued in 2014 made these more attractive by clarifying how after-tax contributions can be treated when an employee retires or otherwise terminates employment. The after-tax contributions can be rolled into another employer Roth 401(k) plan or a Roth IRA, and the earnings on those contributions can be rolled into an IRA or regular 401(k). In both cases the higher contribution limits for after-tax 401(k) allow you to significantly increase your assets with a Roth account, i.e., making them tax-free forever, and the earnings can continue to compound tax-deferred until withdrawal.
Roth IRAs have the added benefit of avoiding required distributions, unlike regular IRAs or 401(k)s. That makes Roth savings an ideal asset to leave to children as part of your estate plan.
Here is our advice on the priority of retirement savings options for 401(k) plans:
- Contribute at least enough to your 401(k) to get your employer’s matching funds.
- Contribute the maximum $18,000 / $24,000 to your 401(k) plan (consult with Parkside about Roth vs regular contributions).
- Contribute the maximum allowable for after-tax contributions to your 401(k) with the expectation of rolling the funds into a Roth IRA or Roth 401(k) in the future.
Of course, contributing tens of thousands of dollars above your normal 401(k) contribution will impact your cash flow, so you should have an emergency fund and sufficient taxable savings in place to ensure that you can increase your retirement savings without needing to tap these funds in the foreseeable future.
There are other retirement savings vehicles for business owners that allow for even larger contributions, which we would be happy to discuss with you.
