The #1 question from subscribers of the Gen Y Wealth Newsletter has been about Roth 401(k)s. Specifically, readers are wondering if they should contribute to a Roth 401(k) or Traditional 401(k).
Up until now, I have always thought a Roth 401(k) as the superior investment. Meaning that majority of young adults should contribute to a Roth 401(k) instead of a Traditional 401(k). After looking a little closer, I no longer believe that.
The purpose of this post is to:
- Define a Roth 401(k)
- Explain why most young adults are better off in a Traditional 401(k)
- Identify the outliers who are better off in a Roth 401(k)
- Answer other common questions I have been receiving regarding Roth 401(k)s
- Start a discussion in the comments about the differences between a Roth v. Traditional 401(k)
What is a Roth 401(k)?
A Roth 401(k) is an option that is available in many employer 401(k)s.
Before 2006, there was no such thing as a Roth 401(k). Employees were only allowed to contribute to a Traditional 401(k).
In a Traditional 401(k), the money you contribute is pre-tax earnings. Instead of getting taxed now, your contributions and earnings on those contributions are allowed to grow in a tax free account until they are withdrawn. At that time, withdrawals are taxed as ordinary income.
In a Roth 401(k), contributions are made post-tax. Therefore, your contributions and earnings are allowed to grow and be withdrawn tax-free.
When deciding which account is right for you, you’re analyzing rather or not it’s beneficial to pay taxes now, using a Roth account, or wait until retirement to pay taxes, using a Traditional account.
Reasons to Contribute to a Roth 401(k)
Let’s first explain why it would make sense to pre-pay taxes now:
- Expect to be significantly higher tax bracket during retirement.
- Need more room for tax protected savings. Both a Roth 401(k) and Traditional 401(k) have the same maximum contribution, at $16,500 in 2011. Even though the limit is the same, doesn’t mean the value is the same because Roth 401(k) contributions are made with after-tax dollars. For someone who is looking to max out their 401(k), they essentially can put away more money in a tax efficient account by investing in a Roth 401(k).
- Expect to receive a pension, which will put them in a higher tax bracket in retirement.
Reasons Not to Contribute to a Roth 401(k)
Next, it’s best to look at scenarios when it doesn’t make sense to pre-pay taxes.
- You expect your tax bracket to be lower than it is now during retirement.
- You plan on moving to a state, like Florida, that has low or no state income tax in retirement and you currently live in a state with a high state income tax.
- Those who are likely to have an irregular income. By contributing to a Roth account, you lose the option to rollover your Traditional 401(K) to a Roth IRA. For example, say you plan to take a year off of work and travel. During that year, you will have very little income, and subsequently, a low tax rate. If that’s the case, you can rollover your Traditional 401(K) to a Roth IRA that year and pay the low income tax rate.
- Eligible for a greater number of deductions and credits since a Traditional 401(k) reduces your taxable income.
Reasons not to Contribute to a 401(K) at All
- If your employer doesn’t match 401(k) contributions and you have not yet started an IRA. The reason being, IRAs are more flexible than 401(k)s. The withdrawal rules are more lenient, and more importantly, you have complete control over your investments and fees.
So What Should You Do?
The worst thing you can do is nothing. Both a Roth 401(k) and Traditional 401(k) are efficient investment strategies.
My opinion is that most members of Gen Y are better off in a Traditional 401(k). The reason being that there’s always the option to rollover to a Roth IRA in the future. Chances are that there will come a time when your taxable income one year is really low. It’s at that time, you can then rollover to a Roth IRA.
The exceptions are for those people with steady jobs who can expect to receive a pension (teachers and other Government employees), those who are looking to contribute more than the max, and those who expect to be in a significantly higher tax bracket in the future and maintain that high income throughout their career and retirement.
The Roth 401(k) v. Traditional 401(k) is a highly debated topic in financial planning. The problem is that all examples contain assumptions about individual’s future earnings and the future of taxes as a whole. Without that information, which one will never have, you can’t accurately predict what the best option is. This is the reason why a Roth vs. Traditional calculator can’t help you out. Calculators assume you will have the same tax rate all the way through your career and retirement, which isn’t correct.
Please add your thoughts or questions in the comments.
Common Questions about Roth 401(k)s
- What happens to employer match? Employer match is always made on a pre-tax basis. If you decide to contribute to a Roth 401(k) and your employer matches, you will technically have two separate accounts.
- Does the Roth IRA have income limits? No, unlike a Roth IRA, anyone can contribute to a Roth 401(k).
- What are the tax consequences of rolling over a Roth 401(K) to a Roth IRA? No, you’re not taxed on rollovers.
- What if my employer doesn’t offer a Roth 401(k)? You’re out of luck for now, but don’t be afraid to ask your boss to add this option.
- Can you contribute to both? Yes, you can contribute to both.
- If one should contribute to a Traditional 401(k) does that mean that they should also contribute to a Traditional IRA? Not necessarily, there are many differences between IRAs and 401(k)s. Lets save that for a future post.