Who's the fairest of them all? Roth 401(k) or traditional 401(k) contributions? This is a dilemma many participants face, and, like most things, the choice depends on your point of view and circumstances.
From an income tax standpoint, a Roth 401(k) is a mirror (or opposite) image of a traditional 401(k) contribution. With the latter, the money you contribute is deducted from your paycheck before taxes are taken out (pretax). However, when you retire, you will be taxed on your withdrawals and earnings.
Now, flip the mirror. A Roth 401(k) contribution is deducted from your paycheck after taxes are taken out. When you take a qualified distribution* in retirement, you pay no taxes on that money or its earnings.
The Roth 401(k) calculator may help you decide which contribution type is right for you. In addition, here are some factors to consider, depending on where you are in your career:
Early career: Usually, your pay and income tax bracket are the lowest early in your career. Typically, you expect your taxes to be higher by retirement, which may make Roth 401(k) contributions more attractive.
Mid-career: At this point, you generally make more money and are in a higher tax bracket. As a result, you may anticipate being in a lower tax bracket when you retire. But, sometimes in retirement, the distributions from your traditional 401(k), IRA and other taxable income may push you into a higher tax bracket, making some Roth contributions now a potentially smart move.
Late career: As you approach retirement, you may find it an advantage that Roth qualified distributions do not count as income in determining if you'll owe taxes on Social Security. Also, at this stage in your career, you may begin to think about leaving money for your family or other heirs. Traditional 401(k)s require you to start taking required minimum distributions at 70½. However, you can roll a Roth 401(k) account to a Roth IRA which requires no minimum distributions during your lifetime, potentially preserving more money for your beneficiaries.
You're not alone if you don't know what your tax rate will be in retirement or how your circumstances will change over the years. To counter this uncertainty, consider tax diversification - spreading your contributions between pretax and Roth. Just as it helps lower your risk by diversifying among different types and styles of stock funds; it may also help diversify your tax exposure by making some contributions pretax and some Roth.
Flipping the mirror back and forth got you dizzy? Remember: 1. The important thing is just to save in the plan. 2. You can change your contribution type at any time. Whichever way you turn the mirror - whether you decide to make pretax 401(k) and/or Roth 401(k) contributions, consistently contributing the most you can is key to building a foundation under your retirement dreams.
*A qualified distribution means that the distribution must be after age 59½, death or disability (in the event of your death, your beneficiaries receive the distribution). Also the Roth 401(k) account must exist for at least five years.
"Retire without taxes," Walter Updegrave, Money magazine, October 2008.
"The price you'll pay to save Social Security and Medicare," Janice Revell, Money magazine, October 2008.
"Designated Roth contributions," Employee Benefit Insights, J.P. Morgan Retirement Plan Services, February 2006.