Is a Roth 401(k) Right for You?
Traditional Individual Retirement Accounts (IRAs) and Roth IRAs have been around for some time now. For those of you unfamiliar with the difference, a Roth is the inverse of a traditional IRA. That is, contributions made to a traditional IRA are tax deductible when made, but taxed when withdrawn, typically beginning at age 71. With a Roth, contributions are not tax deductible, but grow fully tax free over your lifetime. Nowadays more and more companies are adding Roth options to their 401(k) plans, giving employees the same choice they have with their individual retirement plans: immediate tax deductibility but with future taxation vs. no deductibility and no future taxation. The big question: is a Roth 401(k) the right choice for you?
While the idea of tax free growth is compelling, it’s important to understand that mathematically there is no difference between the two approaches. If your marginal tax rate were to remain constant for the rest of your life, and the taxes owed on your traditional 401(k) distributions were paid out of the 401(k), you would end up with the same after-tax amount when you die regardless of which option you chose. In reality, though, your marginal tax rate does change from year to year. Your earnings – which typically grow over time – have a big impact on your marginal tax rate. Your marital status is another big factor. So too are the tax laws which Congress adjusts periodically based on economics and politics. So how can you determine what is the best choice for you?
First, consider your current marginal tax rate. If it’s 15% or less, you’d almost definitely do better with a Roth 401(k). This is a common situation for those in their twenties building their careers. The current tax consequences are smaller than they are likely to be in your future, so putting aside money tax free outweighs the benefit of any current tax reduction.
On the other side, when you are in your fifties and early sixties, you are most likely in the peak earning phase of your life. Your marginal tax bracket is likely to be high relative to what it will be during your retirement years, so getting a tax deduction at that point in time would be worth more. These are the years in which the tax deductibility of a traditional 401(k) would provide greater value.
What if you are in the middle, say age 40 with a marginal tax rate of 28%? That’s a more difficult call. The best solution might be to split your 401(k) contributions equally between the traditional option and the Roth option, assuming your plan allows it.
How much of a tax break to forego today for future tax free growth is largely a matter of your own personal viewpoint on taxes. A Roth 401(k) is one more choice given to you to help manage the tax bite that can have a significant impact on your wealth over time. Following a strategy of tax diversification — maintaining some combination of taxable, tax-deferred, and tax-free accounts for your savings – is probably the best way to insure against the uncertainty of future tax rates.