Roth 401k vs. Traditional 401k: Which Is Best for You?

http://i.bnet.com/blogs/calc3328454small-for-cbs.jpg

On September 27, 2010, President Obama signed the Small Business Jobs Act of 2010, which includes a provision that lets 401k plan participants convert their traditional 401k accounts to a Roth 401k. This might be the necessary nudge that encourages employers to add a Roth 401k feature to their traditional 401k plan. According to a survey by Hewitt Associates, about 29 percent of 401k plans offered a Roth feature in 2009, with another 25 percent likely to add it in 2010.

If you've got the choice, should you use a Roth 401k plan? Let's take a look at the pros and cons of investing your current and future contributions in a Roth 401k vs. a traditional 401k account. (In an upcoming post, I'll examine the pros and cons of converting an existing traditional 401k account to a Roth 401k account.)

First, let's look at the key differences between a Roth 401k and a traditional 401k account:

Contributions to a traditional 401k account aren't subject to federal and state income taxes for the year during which you make the contributions. When you withdraw your accumulated contributions plus investment earnings in retirement, you'll pay ordinary income taxes at the federal and state income tax rates applicable to you at that time. It's the other way around with a Roth 401k account. Contributions are subject to federal and state income taxes in the year you make the contributions. Withdrawals of accumulated contributions and investment earnings at retirement aren't subject to income taxes. Traditional 401k accounts are subject to required minimum distributions (RMD) when you reach age 70-1/2. At that time, you need to withdraw the minimum amount each year, and the amount you withdraw is included in your taxable income. Roth 401k accounts aren't subject to the RMD.

The maximum contributions for either the Roth 401k or the traditional 401k are the same -- $16,500 in 2010. If you contribute to both a Roth 401k and traditional 401k, the sum of your contributions can't exceed that limit. If an employer offers a Roth 401k, most likely it would provide the same matching contributions as for a traditional 401k.

There are really two main reasons to consider investing your current and future contributions in a Roth 401k. The first would be if you believe that your marginal income tax rates will be higher when you retire, compared to today. This might happen if federal and state governments raise income tax rates to meet their substantial deficits, and in fact, that's becoming the conventional wisdom for many financial writers and planners to recommend Roth 401ks or Roth IRAs.

Let's do some math to see how your marginal income tax rates now and in retirement can impact how much money you'll have to spend in retirement. For this example, I'll make some simple assumptions:

You put $10,000 from your salary into your 401k plan in 2011. Your combined marginal federal and state income tax bracket is currently 35 percent. Your 401k accounts earn 5 percent per year. You'll retire in 10 years and withdraw the accumulated contribution that you made in 2011. At that time, your combined marginal income tax rate is still 35 percent.

How much money will you have to spend in 10 years, after paying income taxes, under the traditional 401k vs. the Roth 401k?

If you contribute to the traditional 401k: Since you aren't paying income taxes on the $10,000, you can invest the full amount. At 5 percent annual investment returns, your $10,000 will grow to $16,289 (if you're mathematically inclined, that's $10,000 times 1.05**10). You'll pay 35 percent of that amount in taxes ($5,701), leaving an after-tax amount of $10,588 to spend.

If you contribute to the Roth 401k: You'll pay 35 percent income taxes today on $10,000 -- $3,500 - so that money is gone. You'll have $6,500 left to invest in a Roth 401k. Your $6,500 will grow to $10,588 (that's $6,500 times 1.05**10). Since Roth accounts aren't taxed upon withdrawal, you'll have all this money to spend.

This example shows the following:

If you're in the same marginal income tax bracket now and in retirement, there's no difference in the after-tax amount you have to spend in your retirement between a traditional and Roth 401k. If you're in a higher tax bracket in retirement compared to now, you'll have more money to spend in retirement if you contribute to a Roth 401k. If you're in a lower tax bracket in retirement compared to now, you'll have more money to spend in retirement if you contribute to a traditional 401k.

While many people expect that income tax rates will increase, it's highly possible you'll still be in a lower tax bracket when you retire, even if income taxes are raised. In that case, a traditional 401k will still result in you paying lower income taxes and having more money to spend in retirement. (My next post on this subject will show you the reasons for this conclusion.)

One other note: In the above example, I assumed that if you contribute to the Roth 401k, you'll pay for the income taxes from the amount of salary that you have to invest (from the $10,000). If instead you invest all of the $10,000 in the Roth and pay the $3,500 of income taxes from other sources, in effect that's some extra savings you're forcing yourself to make that is growing in your 401k account. In fact, for this reason, if you can afford to contribute the maximum amount -- $16,500 -- to a Roth and pay the income taxes from other sources, you'll maximize the value of your tax-advantaged savings. This could be a reason to use the Roth 401k.

Now for the second reason to consider a Roth 401k: You can avoid the required minimum distributions (RMD) at age 70-1/2 with Roth 401k accounts, while RMDs apply to traditional 401ks. Technically the RMD applies to Roth 401k accounts, but you can get around this by rolling your Roth 401k to a Roth IRA which doesn't have the RMD. The lack of the RMD might come in handy if you're working in your seventies, as I've written about recently, since your retirement savings can continue to enjoy tax protection. It also might be a good result if you plan to live on just the interest and dividends for retirement income, and pass along the principal to your heirs.

If you don't have a crystal ball on what your income tax rates will be when you retire, or whether the RMD will trip you up when you reach age 70-1/2, then you might consider a form of tax diversification. To do that, you would split your retirement savings so you have equal parts in Roth 401k and traditional 401k accounts.

Whatever you decide, don't let these complications be a reason to put off saving for retirement. You'll be much better off investing in either a traditional 401k or a Roth 401k, compared to spending all your money today.

More on CBS MoneyWatch IRAs and 401k: Generate Retirement Income with Just Interest and Dividends Retirement Planning: What Can We Learn From the Wealthy?