|
Roth 401k Resources |
|
Roth 401k or Traditional 401k ? |
|
Which 401k is best?
|
|
Should employees choose a Roth 401k or a traditional 401k? The answer to this question depends mostly on two variables:
· An individual’s Income Tax rate in retirement. · Whether an individual can afford more than $15,000k in pre-tax 401k contributions.
The basic difference between a Roth 401k and a regular 401k is that the Roth version is funded with after-tax contributions while the traditional 401k is funded with pre-tax contributions. In other word, with a Roth 401k you pay taxes today in return for a tax-free status in retirement. A regular 401k saves you taxes today, but withdrawals are taxed in retirement. Thus, the choice between the two 401k versions comes down to a gamble on whether income taxes will be higher or lower in retirement.
This is a question that nobody can answer with certainty. Marginal income tax rates have declined over the last two decades and there have been several recent attempts to further lower income taxes. If taxes were to continue to decline, a regular 401k would be the better option. The same is true for individuals who expect their marginal tax rate do be lower in retirement as a result of lower incomes.
Yet, economists argue that income taxes will likely rise in the future. The current record of federal budget deficits may eventually result in higher taxes. Similarly, liquidity problems in the Federal Pension and Medicare systems may force future governments to raise tax rates. For these reasons many economist predict slightly increasing income tax rates in the future.
The above chart shows the effect of different tax rate scenarios. Both Roth and regular 401k accounts produce equal returns in a constant tax scenario. Roth 401k accounts are better if taxes are higher in retirement, while regular 401k accounts do better if taxes are lower in retirement.
While different tax rate assumptions will make a difference, affordability of making high 401k contributions may be more significant. Roth 401ks are after-tax accounts and therefore allow employees to stack away more funds relative to using a regular 401k. Maxing out the $15,000 contribution limit after tax equals roughly $21,400 pretax assuming a 30% marginal tax rate. Thus, the Roth 401k effectively increases the amount of money that can be saved for retirement. These additional funds can then build up tax-free over a potentially long period of time. This is especially beneficial to high-income individuals who were previously unable to participate in Roth-type retirement savings accounts due to income limitation. If an employee can afford it, making maximum contributions to a Roth 401k may be the best option.
|
