Very few companies offer a pure pension these days. Individual retirement accounts (IRAs), along with 401(k) and 403(b) plans, make up the bulk of the retirement plans in the private sector. All three types can be utilized straight up or under a Roth option. For example, you have probably heard of Roth IRAs. You can also do the Roth thing with a 401(k) or 403(b) plan. But should you?
The main difference between a standard and Roth account is related to taxation. A standard account is funded with pretax dollars while a Roth account is not. Right off the bat, this may have you thinking that a standard account is better. But not so fast. Roth accounts can be more tax advantageous in many cases.
How Pretax Funding Works
You are likely familiar with how pretax funding works if your company already offers a standard 401(k) or 403(b) plan. With each paycheck, you deduct a certain amount from your employees’ earnings. That money goes directly into their retirement accounts. The company also contributes its share. Neither you nor your employees pay taxes on that money.
When your employees reach retirement age, they will begin taking distributions from their plans. That’s when the tax bill comes due. All 401(k) distributions are considered income; they are taxed in the year they are received.
This is one of the biggest misunderstandings among private sector employees with 401(k) plans. They assume they do not pay any taxes on the money they contribute. In reality, they do; they just pay them later. But it gets worse. They also pay taxes on any earnings they take in their distributions.
How Roth Plans Work
Roth IRAs, 401(k), and 403(b) plans are funded differently. They are funded from disposable income after taxes are taken out. Thus, funding such a plan is not tax advantageous in the here and now. But the advantages become apparent at retirement.
Distributions from Roth accounts are not taxed. You have already paid income taxes on your distributions. As for the account’s earnings, they are left alone – just so long as you don’t take distributions prior to age 59½.
It is quite possible to reduce the total amount you pay in taxes by choosing a Roth account. The Investopedia website offers an example in which two employees in similar financial situations contribute to their respective retirement accounts. The employee who contributed to a standard 401(k) paid more than three times what her Roth account counterpart paid in taxes.
Betting on Your Tax Situation
So, which type of plan is best for you? That depends on your circumstances. You essentially have to bet on your tax situation based on where you are now and where your plans say you will be in the future. A financial advisor with experience in private retirement accounts can advise you.
If you are a business owner, Dallas-based BenefitMall encourages you to look into both Roth and traditional retirement plans on behalf of your employees. They say there are plenty of options out there. As an employer, there are very few differences capable of affecting your bottom line. But as far as your employees go, some of them may be better off with the Roth option.
Of course, there are pros and cons with every retirement plan. You may be in a position of not being able to offer more than one option. In that case, your best bet is to choose the plan that will offer the most benefits to the largest group of employees. Your benefits broker hopefully has enough options for you to look at.