Ask Money

Favor the Roth-401(k)

Chris Farrell Mar 18, 2011

Question: My company is looking to offer Roth401K… is that a better option. I will be 32 early next year and the company contributes 4.5% in either case. Key, Research Triangle Park, NC

Answer: One reason why I tend to favor the choice of a Roth-401(k) is the benefit of withdrawing earnings from the Roth-401(k) tax free in retirement. Another factor is the opportunity for tax diversification over a lifetime of savings. Both the traditional- 401(k) and the Roth-401(k) are good options, but the Roth version is the more intriguing of the two.

As you know, the big difference between a traditional 401(k) and a Roth-401(k) is taxes. Your contributions to a 401(k) are made with pretax dollars. It’s a nice upfront tax break which eases the financial burden of funding the plan. However, you pay your ordinary income tax rate on the savings when it’s withdrawn during retirement. The tax treatment of traditional 401(k)s is why many advisors say stick with it if you believe your tax bracket will be lower in retirement.

With a Roth-401(k), your contributions are made with after-tax dollars. But the earnings on your contributions come out tax free at withdrawal. The tax free withdrawal of money during retirement is especially valuable if you anticipate that your tax rate will be higher when you’re elderly than it is now. By the way, the employer match is made with pretax dollars in a Roth-401(k). It grows in a segregated account and the match will be taxed at your ordinary income tax rate when it’s taken out in retirement.

The research I’ve looked at suggests that the tax free withdrawal of investment gains from the Roth, whether in its IRA or its 401(k) form, is valuable. The younger you are when you start making contributions the longer your money has to compound and (hopefully) the bigger the benefits from tax free withdrawals.

Here’s the thing: Who knows what tax brackets will be 5 to 10 years from now, let alone 30. Many people reasonably expect that taxes will be higher to pay for entitlements like Social Security and Medicare and government services. I’m in that camp, although I do think it’s possible that overall rates will be lower with comprehensive tax reform. (We can always hope, right?)

Whether it’s better to invest in a traditional 401(k) or IRA vs. the Roth-IRA or Roth-401(k) also depends on whether your income is higher or lower several decades from now? You can make an educated guess, but you can’t get rid of the uncertainty.Life has a way of interfering with three decade long predictions.

I like the Roth-401(k) because it adds to your financial options when it comes time to take money out in old age. It’s smart to end up with relatively well diversified portfolios from a tax perspective, such as a Roth-IRA and a traditional 401(k), an IRA, and Roth-401(k). You get greater control over your tax payments this way.

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