How can I get more money into my retirement plan? As a relationship manager for numerous retirement plans, I regularly receive this question from business owners and other highly compensated employees (HCEs). These same individuals are often surprised to learn there are no income restrictions on Roth 401(k) or Roth 403(b) dollars, unlike the income restrictions placed on Roth IRAs. A major advantage being that Roth 401(k)/403(b) contributions begin immediately compounding earnings tax-free. The October 2019, issue of Perspectives contains an article by Jeff Pauza titled “Super-Size Your Roth IRA.” The article provides a comprehensive analysis of the process to fund Roth IRA accounts through after-tax contributions to 401(k) accounts. Unfortunately, not all plans allow for after-tax contributions and those plans that do may be restricted in their use because of unfavorable plan demographics.

In the text that follows, I will attempt to demonstrate why contributing on a Roth basis makes eminent sense, especially for those individuals facing contribution restrictions. In the simplest terms, contributions made by HCEs cannot be excessive when compared to non-HCEs. The IRS requires testing to ensure that the contributions made for lower paid employees are “proportional” to those made for owners and others deemed HCE. These annual non-discrimination tests frequently result in returns of excess contributions to HCE participants, which effectively limits their personal contributions to the plan.

The most important distinguishing factor between Roth and traditional 401(k)/403(b) is when the money is taxed. Traditional 401(k)/403(b) contributions are pre-tax, meaning you can deduct your contributions from your current income, and you will be taxed when the money is withdrawn. Roth 401(k)/403(b) contributions are after-tax, so your deductions will not favorably affect your current tax returns, but the contributions and earnings will be tax-free at retirement, as long as the Roth account has been funded for 5 years.

Weighing now versus later

For many, it comes down to deciding when it is better for you to pay the taxes—now or later. If you are a HCE who is limited on the qualified dollars you are able to set aside within a retirement account, why not opt to pay the taxes now, so that the money within the plan can grow tax-free into retirement?

A tax deduction today can be appealing, but you have to think ahead. Roth contributions have traditionally been recommended for individuals who believe their current marginal income tax rate is lower than it will be when the amounts are withdrawn in retirement years. Roth has also been recommended as a way to diversify the tax treatment of retirement income sources and to provide retirees with tax flexibility. Even if you end up in a lower income tax bracket when you retire, withdrawals from your traditional retirement accounts could potentially place you into a higher tax bracket. Higher taxable income could also increase the cost of your Medicare B premiums in retirement. So, giving up the tax deduction now may be well worth having tax-free withdrawals later on.

The graphic below illustrates the long-term tax savings that can result from making elective deferrals to a Roth source vs. a traditional 401(k)/403(b). I encourage individuals who are restricted in their contributions because of unfavorable non-discrimination test results to view the graphic in terms of the contribution you are permitted to make to the plan. Hypothetically, if you can only defer $5,000 into the qualified retirement plan, it seems reasonable to assume that the best long-term success comes from electing Roth and paying the taxes now vs. waiting. Retirees are commonly disappointed to learn that their retirement savings accounts do not have quite the purchasing power they expected. A Roth account helps to manage those expectations through its predicable tax treatment.

Diversify your retirement account with both traditional and Roth dollars

The good news is that when it comes to a traditional vs. a Roth 401(k)/403(b), you don’t necessarily have to make an all-or-nothing choice. Most plans allow you to split your contributions between the two types of accounts, and decide year-by-year where you want to make your contributions.

It is important to note that employer contributions are always made with pre-tax dollars, so taxes will be due on this portion of the money—and its earnings—once you start taking distributions.

A few added thoughts

With federal income tax rates at historic lows due to the 2017 Tax Act, especially for married couples, now might be the ideal time to defer into a Roth 401(k)/403(b) source. It is unknown if you will pay lower or higher taxes in retirement, but it pays to know that tax-free withdrawals from a Roth will have a much greater after-tax value than a conventional 401(k)/403(b) withdrawal.

Additionally, similar to a traditional 401(k)/403(b)—and unlike a Roth IRA—you do have to take a required minimum distribution (RMD) at age 70½ from a 401(k)/403(b). However, you can easily avoid RMDs by rolling the funds to a Roth IRA. With a Roth IRA, you can leave the money in the account as long as you like, so it is a useful early or “deep” retirement fund.

If you are thinking even farther ahead to estate planning, inherited Roth IRAs are beneficial for your heirs because of the tax-free account status. In addition, the recent passing of the SECURE Act mandates a maximum of 10 years to distribute all assets from retirement plans and Inherited IRAs, which solidifies it is a strategically sound decision to elect deferrals into a Roth 401(k)/403(b) source now.

For highly compensated employees, it can feel as though you are leaving money on the proverbial retirement table. Knowing that you might not get the best deal on taxes, there are still viable options worth exploring, like making Roth 401(k)/403(b) contributions. Whatever you decide, hopefully you are already planning and saving for retirement – and that is the best decision of all.

Posted November 14, 2019. Updated February 8, 2022.