Many employers will begin adding a Roth 401(k) option to their retirement plans over the next few years. If your employer is among them, you will have to make a decision whether to contribute to the traditional 401(k) or the Roth 401(k), or both. Here are some guidelines for determining which is right for you.
A Roth 401(k) is similar to a traditional 401(k), except you do not get a tax deduction for your annual contributions. Instead, when you retire, you will be able to withdraw your contributions and all your earnings tax-free (but traditional 401(k) earnings are taxed at withdrawal). So which is better, paying the taxes now, or paying them in retirement?
The answer depends largely on whether or not you will pay taxes at a lower rate in retirement than you do today. Other factors include how much you can afford to save, the size of your estate, and future tax law changes.
Your Tax Rate Now vs. in Retirement
Calculations comparing the traditional 401(k) to the Roth 401(k) show that if you are going to pay taxes at a higher rate in retirement than you pay today, either due to tax law changes or changes in your income, the Roth 401(k) is likely to be the better choice. Conversely, if you will be in a lower tax rate in retirement, the traditional 401(k) will likely be better.
It is difficult to know what tax rate you might be paying in retirement. However, if you are young or just starting a career, and expect your income to rise significantly over time, you might benefit more from the Roth 401(k). Also, if you believe tax law changes are likely to increase your tax rate over time, you may want to contribute at least some money to a Roth 401(k). This allows you to have some tax-free income in retirement.
However, if you are in your peak earning years now and expect your tax rate in retirement to be lower, you will likely be better off with the traditional 401(k), unless you fall into one of the other categories below.
How Much Can You Afford to Save?
The calculations comparing the traditional 401(k) with the Roth 401(k) assume you have a limited ability to save and would have to reduce your contributions to the Roth 401(k) to pay the taxes upfront. For example, if you only had $15,000 available to save and you pay taxes at the 28% tax rate, you could either contribute the full $15,000 pre-tax to a traditional 401(k), or contribute $10,800 after-tax to the Roth 401(k) ($15,000 minus $4,200 in taxes).
If you can afford to contribute the maximum amount to the Roth 401(k) and pay the added taxes, then the calculations are very much in favor of the Roth 401(k), even if your tax rate falls in retirement. Therefore, people with the capacity to save more should consider the Roth 401(k).
The Size of Your Estate
One problem with traditional 401(k) plans is that they are sometimes subject to double taxation in your estate. The money inside your 401(k) has never been taxed, so an inherent tax liability is included in the value of your account. When you die, the full value of your traditional 401(k), including this income tax liability, is included in your estate for determining estate taxes. If your estate is large enough to be subject to federal estate taxes, you could lose up to 45% of your 401(k) to estate taxes. In addition, your heirs will be forced to take money out of that 401(k) and pay income taxes on these withdrawals.
The Roth 401(k) is a much better asset to leave your heirs. Since you have already paid the income taxes on your Roth 401(k), the value included in your estate is net of these taxes. In addition, you are not required to draw money out of your Roth 401(k) during your lifetime and, when you die, your heirs do not have to pull the money out either. So the money can continue to earn tax-free income indefinitely. This feature is most beneficial to people who are not likely to need the money inside their 401(k) for themselves and will likely pass it on to their heirs.
Future Tax Law Changes
When comparing the traditional 401(k) to the Roth 401(k) you are really comparing a current tax benefit (deductible contributions) with promised future tax benefits (tax-free withdrawals). There is always the possibility that those future benefits will be different from what is promised today. The tax benefits of the traditional 401(k) are certain because you receive them upfront. You should keep in mind that the tax benefits of the Roth 401(k) are perhaps less certain because they are promised in the future and a lot can change between now and then.
If you would like more help determining which plan is best for you, please give us a call at 410-461-3900.