How should I be contributing to my 401(k), traditional or Roth?
My company just started offering an 401k plan in place of a Simple IRA. I am able to contribute into my 401k two different ways, traditional or roth.
From the way I understand it, traditional contributions are taxed when you take money out of the 401k (deferred), whereas roth contributions are pre-taxed.
Under what circumstances would I want to use one over the other? What changes in my life would cause me to change?
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I wrote a brilliant guest post at Don't Mess With Taxes, titled Roth IRAs and Your Retirement Income. (Note - this article now reflects 2012 rates. Just updated)
Simply put, it's an ongoing question of whether your taxes will be higher now than at any point in the future. If you are in the 25% bracket now, it would take quite of bit of money for your withdrawals to put you in that bracket at retirement. In the case of the IRA, you have the opportunity to convert in any year between now and retirement if your rate that year drops for whatever reason.
The simplest case is if you are now in the 25% bracket. I say go pre-tax, and track, year by year what your withdrawal would be if you retired today.
At 15%, but with a good chance for promotion to the 25% bracket, start with Roth flavor and then as you hit 25%, use a combination. This approach would smooth your marginal rate to stay at 15%.
To give you a start to this puzzle, in 2012, a couple has a ,900 standard deduction along with 2 exemptions of 00 each. This means the first ,500 in an IRA comes out tax free at retirement. If you believe in a 4% withdrawal rate, you need a retirement account containing 0K pretax to generate this much money. This tick up with inflation, 2 years ago, it was ,700 and 7K respectively. This is why those who scream "taxes will go up" may be correct, but do you really believe the standard deduction and exemptions will go away?
Edit - and as time passes, and I learn more, new info comes to my attention. The above thoughts not withstanding, there's an issue of taxation of Social Security benefits. This creates a The Phantom Tax Rate Zone which I recently wrote about. A single person with not really too high an income gets thrust into the 46% bracket. Not a typo, 46.25% to be exact.
I'm of the opinion that it doesn't matter much unless something in your life changes in retirement. And since many retirement planners assume a default income target of 80 percent of pre-retirement income, I figure many people's tax bracket isn't moving much.
The most interesting reason I know to Go Roth in a 401k is limits. You can only contribute like k, whether Roth or not. In a traditional contribution, some of the 17k you put in goes to taxes when taken out, but in a Roth contribution you pay taxes up front. So if you have more than k to invest, Roth lets you sneak some more into the system.
The Finance Buff discusses why the Roth 401k is often disadvantaged compared to a Traditional 401k in the article The Case Against the Roth 401k, including the following reasons (paraphrased):
Contributions to the 401k come from the "top" of your highest tax bracket rate but withdrawals fill in from the "bottom". For example, suppose you are in the 28% tax bracket. Every marginal dollar you contribute to the Traditional 401k reduces your tax burden by .28 cents. However, when withdrawing, the first ,150 of income is tax-free (from standard deduction and exemption, 2014 numbers; ,300 for married couples, joint filing). The next dollars are at the 10% tax bracket, and so on. This is an advantage for the Traditional 401k only if you earn less when withdrawing than you did when contributing, a reasonable assumption.
Avoid High State Income Tax. There are many states that have low or no state income tax. If you live in a state with a high income tax, paying tax now through the Roth 401k reduces the benefit of moving to a state with a lower income tax rate.
Avoid triggering credit phaseouts. Many tax credits (e.g. student loan interest, child tax credit, Hope credit, Roth IRA eligibility, etc.) begin phasing out as your income increases. Contributing to the Traditional 401k can help you realize more of those credits when you starting running up against those limits.
As described in the article, if these items don't apply, contributing to the Roth 401k can be a valuable component of tax diversification.
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