Is a ROTH 401k a good option compared to a traditional 401k?

November 2, 2006 8:46 AM

Yes, you read that right, R0TH 401k--not ROTH IRA. My company has just given us the option to start a Roth 401k. At the present time I am contributing to a traditional 401k and a ROTH IRA. It has been said for a while--well, as long as I've been listening, that you would typically want to go with a ROTH and pay the taxes on the front-end. Would this concept apply directly to a ROTH 401k, too? Here is some addition information: At present I'm contributing 10%+6%(matching) to my 401k. I am 25 with hopes of a typical retirement.
posted by cmorris to work & money (6 comments total)

It's "Roth" (named after a guy, not an acronym)

Anyway, this is a really hard question. Basically, if you think that you'll be taxed at a higher rate when you retire, you want Roth, otherwise, traditional. This is tough for people our age since I don't think it's possible at all to predict tax rates in the future.
Your income and tax level now is also a factor in this decision - if you're making 50k and filing jointly, the answer is a lot different than if you're making 80k filing singly.

The main reason you want a Roth IRA rather than a Traditional IRA is that the investment limit is $4k regardless of tax status, so a Roth IRA "holds more". Unless you're hitting the $15k 401(k) contribution limit, it doesn't really matter here. If you are, good job!, and definitely go for a Roth contribution instead.

Argument for: Roth vehicles give you more predictability - you know exactly how much your stuff is worth without having to know what the tax rates in the future are. Given current deficit spending and low fertility rates, it's likely that we'll be taxed more in the future regardless of income levels, plus if you semi-retire you'll be looking at a higher marginal income.

Argument against: Since you have a Roth IRA, you should be diversifying the tax status of your retirement. If you retire early with low expenses (paid-off house, good health), you'll be making less money than you are now.

I have a Roth IRA as well and recently switched my 401(k) contributions from 100% traditional to 100% Roth. I'm not fully convinced either way despite spending a lot of time looking in to this. It's totally reasonable to hedge your bets and split it up if your employer allows it.
posted by 0xFCAF at 9:49 AM on November 2, 2006

I would say go for it, as long as you'll get the same employer match on the Roth 401k. (Considering employer match is free money.) You will pay taxes on the money before it gets invested, but you won't pay taxes on any of the gains as long as you don't withdraw till you're 59 1/2. Sounds like a bargain. And, it has the same limit as a traditional 401k, that is, $15k per year.

Here's a good article about the Roth 401k.
posted by knave at 9:49 AM on November 2, 2006

The answer to your question is pretty much "yes." However, be aware that your decision has tax consequences - contributing to a normal 401(k) lowers your AGI by 1 dollar for every dollar you contribute, whereas contributing to the Roth 401(k) doesn't lower your AGI at all. (Just like the IRAs, actually.)

If you're right on the cusp of a nasty tax bracket bump, and you have predictable income, you might want to manipulate the contributions to stay in the lower bracket.

Also, since you're paying tax on the Roth, contributing the exact same dollar amount to it as you would to the regular 401(k) will reduce your take-home net pay. If that's going to cause you contribute less money to the Roth than you would have contributed to the regular 401(k), then in the long run it doesn't make much difference what you do.

Basically I, and others, prefer the Roth because tax today is a known quantity and tax tomorrow is not. I can envision a scenario where, 40 years from now, good old Uncle Sam institutes, for example, a means test for tax rates on traditional IRA/401(k) withdrawals, so that folks whose investments did well were severely penalized - point being that, although you're told your traditional 401(k) and IRA withdrawals will be taxed, you're not being told how much.

The Roth, on the other hand, is supposed to be available to you for tax-free withdrawals once you begin your retirement. This takes the responsibility for preservation of your retirement out of the hands of the House Ways and Means Committee (I mean, seriously, these guys pretty much lower the bar for fiscal prudence every year).
posted by ikkyu2 at 11:17 AM on November 2, 2006

To elaborate on Ikkyu's reasonable concern (And if you wonder if sensible saving and fiscal prudence might be punished on retirement, be assured it absolutely will applying for college financial aid for your children. But I digress.) Even if future lawmakers don't punish savers, it's a fact that tax rates are currently at an all-time low and we're consequently running enormous budget deficits. Whoever will making the laws, it's inevitable that tax rates in the future must be higher. If you can keep the match, go for the Roth.
posted by mojohand at 12:29 PM on November 2, 2006

Unless, of course, you want to retire somewhere outside the United States. Say you were planning on retiring in Canada. The Canada/US tax treaty does not recognize the deferred tax status of the Roth (IRA or 401k), so you would be taxed when contributing in the US and when withdrawing in Canada. Ouch.
posted by crazycanuck at 1:23 PM on November 2, 2006

I also given some thought to traditional vs. Roth IRAs. The trade off is whether your tax rate will be higher or lower in retirement. With the recent trends in the growth of fiscally irresponsible debt in addition to the explosion in Medicare costs, I think the odds are pretty good that taxes rates in the future will be significantly higher.

Some people think that the government will tax Roth withdrawals in the future, but I think that is unlikely. The reason is that few people keep track of the cost basis of their Roth nor are they required to. That means it would be difficult to determine how much of your Roth has already been taxed and how much has not. That doesn't mean that they can't come up with some method of taxing a Roth, but it would be extremely difficult to come up with a reasonable way to do it.

The worst thing that could happen from the point of view of a Roth would be to reduce or eliminate income taxes and replace them with a national sales or value added tax. That would be the extreme case in which your retirement income tax rate is much, much lower than your current rate, which is bad for a Roth. This is one of the reasons I think that a national sales tax is unlikely to be implemented. Seniors citizens would scream bloody murder.
posted by JackFlash at 5:41 PM on November 2, 2006