05 Nov To Roth or not? Choosing your first 401(k)

Q. My daughter is just starting out in the working world. She is beginning her very first full-time permanent job and must elect whether to enroll in a Roth 401(k) or in a non-Roth 401(k). Which should she pick?
— Trying to help

A. We’re glad to hear your daughter is going to start saving for her future. By starting to save at a young age, she’s going to be able to build substantial wealth over time.

Before deciding which kind of 401(k) she should use, she first needs to decide how much she plans to contribute.

At a minimum, she will want to contribute enough to capture any matching contributions that her employer may make, said Adam Leone, a certified financial planner with Modera Wealth Management in Westwood.

Leone said given that this is her first real job, the Roth 401(k) is appealing because she has a very long time to take advantage of the tax-free growth that can build inside a Roth account.

Her Roth savings will grow tax-deferred, and when she takes the money out of the Roth in retirement, the funds come out completely tax-free. That compares to the traditional 401(k) — the non-Roth, as you put it — which allows for tax-deferred growth, but when your daughter eventually takes money out of the account, the withdrawals will be taxed.

Future taxation of the account isn’t the only consideration. Her choice will impact her taxes today. Contributions to a traditional 401(k) will lower her taxable income now, and the Roth won’t.

But her income and taxes are probably as low as they will ever be, Leone said.

“If that is true, she can take advantage of the Roth 401(k) now and then switch to the traditional pre-tax 401(k) later in her career when the tax deduction is more valuable to her,” Leone said.

Another option is to split the contributions between both types of accounts.

Leone said if your daughter’s taxable income — adjusted gross income less deductions — will be more than $38,000, her marginal tax bracket will be 25 percent. If that’s the case, she may want to use both kinds of 401(k) accounts, which is permitted by most 401(k) plans. Doing so would allow her to save on both a pre-tax and post-tax basis, he said.

A final aspect to consider is the variety and cost of the investment options in her plan, Leone said.

“If she has limited options or the expense ratios are higher than average for their category, she may want to consider contributing only enough to the 401(k) to capture the company match and then contributing additional funds to a traditional or Roth IRA,” Leone said. “The concepts are the same, just the account types are different.”

If she follows that strategy, she should speak to her tax preparer to make sure she can confirm her eligibility, and that the correct forms are filed with her tax return.

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This story was first posted in November 2015.