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Roth 401(k) vs. Traditional 401(k)

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I’m excited to publish the first guest post on this blog.  Joe is a personal financial blogger posting at his site www.joetaxpayer.com.  Joe was kind enough to share his thoughts on choosing between a Traditional 401(k) and a Roth 401(k) if your plan allows for this option.  Check out Joe’s Plutus Award winning blog for more excellent insights.

Today, let’s look at the differences between the Traditional 401(k) and the Roth 401(k). Similar to the Traditional IRA, the Traditional 401(k) permits you to make deposits to your account, pre-tax, and then, at retirement, withdraw money and pay tax upon withdrawal. The Roth 401(k) is similar to the Roth IRA, in that you make deposits with post-tax money, but will be able to withdraw both deposits and growth with no further taxes due after you retire.

Tax Planning Considerations

Seems pretty simple, no? Not so fast. It’s easy enough to look at your current marginal rate, which is the tax you pay on that last dollar of income. When you look at your total tax bill over your total income, you get an average rate which isn’t as useful for this analysis. The tougher thing is to know what your rate will be in retirement. Do you have a traditional pension from your current or former employer? How much have you already saved in pre-tax 401(k) accounts or Traditional IRAs? These are some of the factors you’ll need to consider when starting to think about whether to choose the Roth 401(k).

Let’s take a closer look at the numbers. In 2012 a couple, married filing joint, will have a standard deduction of $11,900 along with two exemptions of $3,800 each for a total $19,500 that comes off the top when calculating their taxable income. If they itemize, they may have a Schedule A showing higher than $11,900, but that’s the minimum this year. It then takes $70,700 of taxable income to hit the top of the 15% bracket (see chart above). Just over $90,000 per year gross income and still in the 15% bracket. If you are comfortable taking 4% per year withdrawal, it would take $2,250,000 in pretax accounts to fund the $90,000 per year withdrawal.

Saving your way to a higher bracket isn’t easy, nor is it so common. It can easily occur, however, with an employer whose pension is generous, or for those whose 401(k) is heavily invested in investments that have done very well. In such situations, using the Roth 401(k), funded with after tax dollars, will keep your pretax savings from snowballing out of control, potentially putting you in a higher bracket come withdrawal time. Even if you choose the Roth, any employer deposit remains on the traditional, pretax side.

Other Considerations

Last, it’s not just about now vs. retirement. When you change jobs you should consider rolling your 401(k) money into an IRA. During the course of your life, in any year your income is below average you should take the opportunity to convert a bit of your Traditional IRA to a Roth IRA, reporting the conversion as income, but at a lower than average bracket.

As you approach retirement, the big picture becomes more clear, and the last years before you retire can help you balance your accounts between the Traditional 401(k)/IRA and Roth flavors of these accounts. For the working couple where one spouse has retired earlier than the other, the years where a single check is coming in is the ideal time to deposit to the Roth and to convert a bit from the Traditional accounts before the larger withdrawal start to come during full retirement living.

Check out guest author Joe’s blog www.joetaxpayer.com for more great articles like this one.

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Comments

  1. Good thoughts to consider for future years; thanks for breaking it down to that level of detail!

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  1. [...] at Roger Wohlner’s The Chicago Financial Planner, I wrote Roth 401(k) vs. Traditional 401(k). If you have this choice and need help deciding, take a look, and tell Roger, Joe sent [...]

  2. [...] Wohlner @ The Chicago Financial Planner writes Roth 401(k) vs. Traditional 401(k) – Joe from JoeTaxpayer Blog shares his insights on choosing between a Traditional 401(k) and [...]

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