- Republicans are reportedly considering capping pre-tax 401(k) contributions as part of President Donald Trump’s tax plan. Proposals suggest the limit will apply to pre-tax contributions, and that additional savings up to the current max would go toward a Roth 401(k). Harvard researchers have found that most people who save in a Roth 401(k) end up with more purchasing power in retirement.
President Donald Trump’s tax plan could be coming for your 401(k).
But the proposed changes might actually be a good thing – especially if you’re young.
As with many aspects of Trump’s tax plan, details are sparse. But some versions of the rumored proposal indicate that additional retirement savings would still be possible, but would be directed to a post-tax Roth 401(k) instead. In other words, your retirement savings won’t be limited, but when and how you pay taxes on that money may change.
The financial services industry, who promoted the initial reports, might not like that, but Harvard researchers who espouse the benefits of the Roth 401(k) may beg to differ.
A Roth 401(k) forces you to pay taxes sooner – which isn’t necessarily a bad thing
Roth 401(k) contributions are deducted from your paycheck, just like traditional 401(k) contributions. Both types of accounts share the same maximum contribution and investment options. The only difference is when you pay taxes.
Saving in a traditional 401(k) is cheaper today because it allows you to postpone paying taxes until you begin taking withdrawals in retirement. That’s one reason financial professionals like the account so much – theoretically, people will put more money into the account if it takes less of their paycheck to do so.
Roth 401(k) contributions are deducted from your paycheck as well, but the amount is funded with your take-home pay instead. Meaning, for every $1,000 you save for retirement, you’ll have to fork over $200 or so to the IRS, depending on your tax bracket.
But Harvard researchers found that most people don’t think about taxes when deciding how much to save for retirement. The majority of Americans just pick an amount – or in the case of auto-enrollment, employers pick an amount – and start saving. That could be 10% of income, for example, or $50 per paycheck.
Although it’s more expensive to save in a Roth 401(k) today, those who use the account will likely end up better off in retirement, according to John Beshears, the lead author of the Harvard study and a behavioral economist and assistant professor of business administration at Harvard Business School.
Beshears explained his research to the Wall Street Journal earlier this year:
“If a worker saves $5,000 a year in a 401(k) for 40 years and earns 5% return a year, the final balance will be more than $600,000. If the 401(k) is a Roth, the full balance is available for retirement spending. If the 401(k) is a traditional one, taxes are due on the balance. Let’s say the person’s tax rate is 20% in retirement. That makes for a difference of $120,000 in spending power, which a life annuity will translate into about $700 a month in extra spending.”
A Roth 401(k) isn’t always better financially – for example if you work in a high-tax state now but plan to retire in a lower-tax state in the future – but for the majority of Americans, the Harvard study shows a Roth 401(k) leads to increased spending power in retirement.
Saving in a Roth 401(k) is smart, regardless of tax plan proposals
Whether or not 401(k) changes are ultimately part of tax reform – Trump weighed in on Twitter to say, “There will be NO change to your 401(k)” – it’s worth considering saving in a Roth 401(k) anyway.
Not all companies offer the account, but according to a recent report from Vanguard, the option is on the rise. Nearly two-thirds of Vanguard 401(k) plans include the Roth feature, up from 49% in 2012. Among employees who have access to it, 13% elect to use it.
Roth 401(k) accounts are most popular among 25 to 34-year-olds, with 17% choosing to save for retirement on a post-tax basis, more than twice the number of 55 to 64-year-olds – 8% – who use the account.
Most companies offer some form of guidance in choosing which retirement account and investments are best. A visit to the HR department at your company can help point you in the right direction. Often the 401(k) provider has a toll-free number for plan participants to call and get their questions answered.
Regardless of the account you choose, the younger you start saving for retirement, the better off you’ll be.