Roth or Pre-Tax 401(k): 3 Questions to Ask Now

Eggs

More and more companies are offering their employees a choice of either pre-tax or post-tax (Roth) contributions within their 401(k) plans. According to a recent survey by Callan, the percent of retirement plans that offer a Roth option grew from 49% in 2010 to 71% in 2017.

But as with many aspects of investing, more choices can lead to confusion. If you’re faced with the choice between making a pre-tax or Roth 401(k) contribution, how do you know which one is right for you?

The question is especially timely now, when most of us are in the process of filing our taxes and many may be considering how to reduce their tax payments next year. And the recently passed Tax Cuts and Jobs Act makes the decision even more complicated, as tax rates will be changing from year to year as the new law is fully implemented.

Consider these three questions to help you decide:

1. Taxes – pay them now or pay them later?

Both Roth and pre-tax contributions offer the benefit of tax-sheltered growth while you’re working. When you contribute with pre-tax dollars, qualified withdrawals in retirement are taxed as ordinary income. By contrast, Roth contributions invest post-tax dollars, meaning qualified withdrawals come out tax free.

There are calculators that can help you determine the tradeoffs—check to see if your employer offers one on your plan’s website. But one of the most important variables is your estimated tax rate during retirement. If you think your tax rate will be lower in retirement than during your working years, it may make sense to go with a pre-tax contribution.

Alternatively, you might choose the Roth option if you expect your savings to generate a higher income in retirement than you currently take home. And remember, the total amount you withdraw in retirement will likely be greater than any amount you contributed, given the power of compounding returns.

2. Will your choice impact how much you save?

The choice between a Roth or pre-tax contribution will make a difference in your take home pay. All else being equal, when you make a Roth contribution, your take home pay will be lower than the same contribution made with pre-tax dollars. If a larger paycheck today will encourage you to save more than you would otherwise, you may be better off sticking with a pre-tax contribution.

recent study from the Harvard Business School, however, shows that most people contribute the same amount to a 401(k) regardless of which contribution type they make. This is likely because most of us invest based on a fixed percentage of our pay (such as 10%), rather than by trying to optimize both our take home pay and our retirement savings.

3. How important is future tax flexibility?

Perhaps the best choice you can make is to not pick one over the other, especially since future tax rates are hard to predict. If your employer offers both options, you can always divide your contributions between Roth and pre-tax. That can give you some tax benefit today while enabling you to diversify your potential sources of income—including how much is subject to tax—when you’re retired. Many financial planners refer to this as “tax diversification” and, like investment diversification, can pay dividends today and down the road.

Please note that regardless of which path you choose, any eligible employer match may be contributed pre-tax. Make sure to reach out your employer or recordkeeper for specific plan details.

Paul Mele is the Head of Participant Engagement for BlackRock’s U.S. & Canada Defined Contribution (USDC) Group and a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2018 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

 

 

The Case for Technology in 2018

Circuitboard

The performance of technology stocks over the recent past has been striking: In 2017, for example, the information technology sector of the S&P 500 posted a 38% return, while the broader S&P 500 Index gained 22% (Source: Bloomberg data). Perhaps even more impressive is the fact that technology is responsible for almost 30% of the total gains of the S&P 500 Index over the last five years (Source: Bloomberg, as of 2/28/18).

In investing, however, past is not prologue. So the question is: Can the good times roll on? We may not see another year like 2017, but there are three reasons why technology continues to be one of our top sector picks.

Strong earnings momentum

The BlackRock Investment Institute recently upgraded U.S. equities from neutral to overweight on the basis of significant earnings growth expectations driven by a supportive macroeconomic environment—and potentially boosted by fiscal stimulus. This thesis equally applies to technology.

This reporting season, 88% of IT companies in the S&P 500 Index posted positive earnings surprises—the highest proportion of all the sectors—while recording 22.5% aggregate year-on-year earnings growth compared to the broad Index’s 14.3% (Source: BlackRock, Bloomberg, as of 3/5/2018). This has translated into strong equity market performance year-to-date, as depicted below. Notably, the other high-flying sector—consumer discretionary—also includes two tech-powered giants: Amazon and Netflix.

Total Return Earnings Surprises

Significant cash balances

Many established technology companies are cash rich, commanding strong balance sheet positions and ample investment firepower. (Source: Bloomberg, as of 11/2/2018).

This offers a number of potential advantages. First, these companies potentially are insulated from the impact of rising interest rates, and may even benefit. As we recently noted, technology historically has been among the sectors the most insulated from yield curve shifts.

In addition, one of the consequences of the recent tax legislation is the prospect of companies repatriating cash back to the U.S. at favorable rates. This increases the potential for dividends, share buybacks or increased mergers and acquisition activity. At the same time, increasing capital expenditure or research and development (R&D) spending may be supportive of the sector in the longer term.

Investing in long-term trends

The impacts of technological disruption extend beyond the confines of old fashioned sector classifications. As we highlighted in October, investing in technology allows investors to tap into large scale, transformational shifts in the way entire industries operate—whether it be the growth of “big data,” cloud-based enterprise and infrastructure solutions, cyber security or the intrinsic importance of semiconductors. Additionally, the growth of online shopping is displacing traditional brick-and-mortar retail and could change the face of commercial real estate markets. These forces result in the tech sector exhibiting a strong secular growth profile and in our view, help justify a premium in the form of higher valuations.

Investors can choose from a wide range of tech exposures.  For example, exchange traded funds (ETFs) tracking broad technology indexes can include large cap technology stalwarts. Alternatively, ETFs tracking more focused sub-indexes allow investors to target companies with network and cyber security business lines or a software focus. Investors seeking a more economically sensitive exposure may consider a semiconductor ETF, providing access to the growth of companies that design, manufacture or distribute semiconductors—the vital components of many electronics and computer devices.

Bottom line

We believe earnings momentum, strong balance sheets and economy-wide transformational forces of innovation and disruption can help provide both cyclical and structural support for technology stocks in 2018. Investors seeking exposure to technological growth can consider taking a targeted approach to their sector definitions.

Chris Dhanraj is the Head of the ETF Investment Strategy team in iShares and a regular contributor to The Blog.

 

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The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

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