I love the Roth IRA. Tax-free income in retirement is a truly great deal.
As more employers provide the option of a Roth 401(k), you may be faced with this question: Do I contribute to a Roth 401(k) or a traditional 401(k)? The answer depends on your income tax rate now and what it might be at retirement. Before offering any explanation, here is some background:
How These Retirement Plans Work
If you need to think: what is taxed now, what is taxed later, and what grows in between, what are we talking about?
Tax deferred growth – Earnings on both the traditional 401(k) and the Roth 401(k) are not taxed. Not paying taxes on investments in your retirement account means more grows and compounds tax-free – that is why contributing to a retirement plan is so important.
Contributions – Contributions to a traditional 401(k) are made “pre-tax,” meaning that the amount contributed is excluded from your taxable income for the year.
Contributions to a Roth 401(k) are made after tax – they are not excluded from taxable income.
Withdrawals – Withdrawals from a traditional 401(k) are taxed in the year of withdrawal.
Withdrawals from the Roth plans are not taxed.
Other rules – There are penalties for withdrawal before reaching age 59½, unless certain exceptions are met, and you must begin withdrawing when you reach age 70½ under the IRS Required Minimum Distribution or “RMD” rules. For more on RMD rules, see https://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-Required-Minimum-Distributions-(RMDs).
How you decide into which plan you should contribute
If you have a high tax rate now, and expect a low tax rate later, pick the traditional 401(k)
The traditional plan is better because get the current tax deduction, reducing taxes now at the higher tax rate. This may be true for people in middle or later years of employment.
Note: this is only financially better if you invest the amount of taxes saved.
If you have a low tax rate now, and expect a high tax rate later, pick the Roth 401(k)
The Roth plan is better because you avoid higher taxes later. This may be true for most people starting work now.
If expect your tax rate later will be the same as it is now, pick the Roth 401(k)
The Roth plan has other benefits described below.
Hedging your bets
If you are not sure of your tax rates, or if you just want more options because you cannot predict, then you can opt to combine plans. For example, you can contribute to your traditional 401(k) up to the employer match and then put the rest in a Roth IRA, if the contribution limits allow.
When you change jobs, you can convert a 401(k) to a Roth IRA, but doing so is a taxable event. If you expect your tax rate to be higher in the future, this is a good move. However, you will want to pay taxes due from other sources. If you have to take funds from the IRA to pay the taxes, you reduce the amount going into the Roth IRA which dramatically reduces the future benefit.
If you convert after-tax contributions made to a traditional 401(k) or non-deductible IRA, you have less on which taxes are due because the after-tax portion is not taxed in converting to a Roth IRA.
While a Roth 401(k) is subject to RMD, a Roth IRA is not. If you can re-characterize the Roth 401(k) to a Roth IRA, you avoid the RMD. This may mean that you pass more on to your heirs. Also, you may gain investment flexibility compared to a company plan.
If you use a Roth plan, then your taxable income at retirement will be less than if you were withdrawing from a traditional plan where withdrawals are taxed. This could lessen tax due on social security benefits.
On the other hand, if you expect to use funds in your retirement plan to donate to a charity, you are better off getting the tax savings for yourself now. The charity is not subject to much if any income tax.
Also, if you expect your heirs to receive your retirement plan assets and know that those heirs will be in a lower income tax bracket, you should use a traditional plan now to get the tax benefit for yourself. How can you possibly determine that heirs will get more of your retirement than you and also be in a lower tax bracket? I cannot imagine – well, maybe I can, but none of the ideas sound good. Anyway, it seemed like a good idea to mention (they teach you to think this way in law school).
Deciding can be tricky!
We became quite technical in this post, so let me know if you have questions as you decide.