21 Nov Choosing between a Roth 401(k) or a traditional 401(k)
Q. My employer gives me the choice of a traditional 401(k) or a Roth 401(k). How do I know which way to go?
A. Great question. Your decision may impact your taxes today, and your possible taxes owed when you retire.
A traditional 401(k) allows you to contribute pre-tax dollars, so your contributions lower your taxable income. When you take money out in retirement, it’s taxable income, said Brian Power, a certified financial planner with Gateway Advisory in Westfield.
That’s different from a Roth 401(k), which provides a tax break down the road.
“After-tax dollars go into the account now, but when you take the money out in retirement, they’re tax free withdrawals,” Power said.
Generally, Power said, the traditional 401(k) should be chosen if you are in a higher tax bracket now than you will be in retirement or once you stop working full time. He said a Roth 401(k) should be chosen if you are in a lower tax bracket now than you will be in retirement or once you stop working full time, such as folks with pensions and deferred compensation, or if tax rates continue to climb.
“Since no one knows for sure if their tax bracket will be higher or lower in retirement, I like the idea of hedging your bets and contributing to both types of 401(k) accounts,” Power said. “This will also diversify someone’s retirement income since some of the retirement account withdrawals will be taxable and some will be tax-free.”
But before you decide for sure, an analysis that needs to be done to review the benefit you get from the tax savings of each option, said Michael Gibney, a certified financial planner with Highland Financial in Riverdale.
He also likes the idea of diversifying your tax liability in retirement.
“If your current salary is so high that the current contribution has little effect on your tax savings, you may want to begin to contribute to a Roth because the future benefit may be greater since you are not subject to Required Minimum Distributions (RMDs) from a Roth,” Gibney said.
Also, if you have a sizable 401k/IRA balance — sizable enough that distributions alone may push you into a higher tax bracket when you are retired — you should consider that a Roth contribution now will reduce your future tax liability, he said, noting that occurrence is more common than you might think.
“Consider someone who was left an `inherited IRA,’ who is required to take distributions every year,” Gibney said. “As they get older, the distributions get larger, and they may eventually be taking distributions from a couple of IRAs once their own RMDs kick in. A Roth would certainly be welcome because there are no RMDs.”
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This story was first posted in November 2014.NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.