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Should I ditch my traditional 401(k) for the Roth 401(k)?

So it looks like my employer will be offering the new Roth 401(k) sometime this spring. Should I ditch my traditional 401(k) for the new Roth 401(k)?

As always before making a financial decision I turned to the trusty Internet for answers. Most of the articles I came across suggest that I am better off with a Roth 401(k) if I think I will be in a higher tax bracket in retirement than I’m in today. This appears to be the case for most young workers who are earning only a fraction of what we can expect to make in our peak earning years. Financial experts suggest that those in the 15 – 20% tax bracket should consider Roth 401(k)s. Pay the taxes now, they say, in the hopes of paying fewer taxes in retirement.

Of course all of the articles point out that no one can predict future tax rates. But most advisors expect the government to raise rates not lower them, especially as the budget deficits grow and the lack of funds for social security becomes a larger issue. Also workers should recognize that social security income can be taxable up to 85%. (Of course, most of us don’t believe social security will be around by the time we retire.) And that large withdrawals of traditional retirement accounts can boost your income and thus your tax bracket during retirement.

So here’s the nitty-gritty on Roth 401(k)s:

You can only save up to $15,000 in a 401(k) account this year, regardless of whether it is a Roth or a traditional. You can divvy this money up as you desire, for example putting $10,000 in a Roth 401(k) and $5,000 in a traditional 401(k). You can put $15,000 in a Traditional 401(k) or $15,000 in a Roth 401(k). But you cannot exceed the $15,000 limit. In other words you cannot put $15,000 into a traditional 401(k) and $15,000 into a Roth 401(k).

If your employer currently matches your pretax contributions they will also match your Roth 401(k) contributions. (But they will not match both.) However, the employer’s contributions will be held in a separate account and taxed as ordinary income when you withdraw the money. I believe my employer will continue to put the matched funds in my traditional 401(k) even though I plan to contribute to the Roth 401(k).

At retirement the Roth 401(k) can be rolled into a Roth IRA. The good news is that Roth IRAs currently do not have minimum distribution rules, therefore if you roll your Roth 401(k) into the Roth IRA at retirement you do not need to draw down your money as quickly as traditional IRAs require.

Even better news. Since distributions from the Roth 401(k) and/or Roth IRA are not taxed they will be more valuable when you retire. I found a great article which describes these benefits in detail. For example, if you’re in the 25% tax bracket you have to withdraw $133.33 from a traditional account to have $100 in spending money. $33.33 will be used to pay tax on the distribution. Saving in a Roth account can make you 53% wealthier in retirement!

The only down side as I see it, is that you will receive less money each week in your paycheck. This occurs because you must pay the tax on 100% of the money you contribute to the Roth 401(k). For example, suppose a single filer making $90,000 a year contributed the maximum, $15,000, to a traditional 401(k). In the 28% bracket, her tax would be $21,000. But that same $15,000 contributed to a Roth 401(k) would leave her with a bill of $25,200, a difference of $4,200. Also, no one knows whether or not the Roth 401(k) will continue past the 2010 expiration date. If the Roth 401(k) is not continued future contributions will not be allowed.

Of course my description above is simplified. For more information or to decide how you should invest your retirement money check out the articles below:

Smart Money article w/ Nifty Calculator    MSN Money article

Daniel

Friday 7th of April 2006

I would think about it before you rush all your money into the Roth 401(k). You should first contribute enough to reach your employer's match, usually only done in a traditional 401(k). Next, you should use a Roth IRA, rather than the 401(k) because it has non-financial benefits (e.g., ability to withdraw for first home, disability, do not have to take withdrawals after 70.5, etc.).

Once you've maxed your Roth IRA, go back to your original determination.

It is NOT certain that tax rates will be higher (although it is likely). We very well could 30 years from now be in a flat tax economy or a sales tax economy, then the Roth would yield less benefits. The best bet is to 50/50 mix of both, when you retire, you have the option of withdrawing from the one that yields the most benefits first before tapping into the other one.

calgirlfinance

Thursday 6th of April 2006

I would definitely go for the Roth 401K. I even emailed my employer asking for it. And this might be a limited time opportunity since the Roth IRA is set to expire in a few years (2010 I think) unless it's renewed.