Roth 401(k) versus traditional 401(k)

March 2, 2009

Everyone says to take advantage of the 401(k), because most employers will offer a match to your contributions. But some don’t, including mine, so I looked into which plan would be best for me — a recent grad with an optimistic fiscal future.

This brief overview by Ramit Sethi on iwillteachyoutoberich is great for getting the basic vocabulary down. After that, the most helpful article I found was on CNN Money, by Walter Updegrave. The Wikipedia entry on Roth 401(k)s also isn’t a bad resource.

I realized after reading all this that one should participate in both plans to “hedge your bets” — finance-speak for covering all your bases.  The real decisions are whether you’ll be putting more into one or the other and what your 401(k) allocations look like.  There’s usually too much un-funny funny in the Motley Fool for my taste, but their page on picking what goes into your 401(k) is very helpful.

Anyway, back to this Roth/traditional 401(k) business.

What Tax Brackets Have To Do With It

Updegrave shows that the tax savings are equal in the end if you stay in the same tax bracket, say, 25 percent. But if you expect to be in a higher tax bracket, say 33 percent, then why not get it taxed at 25 percent and withdraw tax-free when you’re old?  Furthermore, it’s not for certain that tax rates will increase in the future, but they probably will. We’ve all heard Obama say he’s increasing taxes for people who make more than 200,000, right? I’m not saying I will ever make more than that, but *just* in case…

You could you expect to be in a higher tax bracket if you are just starting your career and plan to be making a lot more money in the next forty years. You could expect to be in a lower tax bracket if you are already at the peak of your career and will be taking it down a notch in the next two decades or so.

How Much Can You Put In?

Then there’s the question if which one lets you put more money in from the get-go. max is 15,500 for both.

If Roth after-tax in 25 percent bracket, then you invest 15,500 pre-tax (which becomes 11,625) and even more (3,375 x 1.25 = 4,218.75) up to 15,500 to max it out. so you put more in from the start. If traditional 401k, then you max it out at 15,500 pre-tax and should invest the tax savings (4,218.75) in stocks. if your stocks do well then you end up with more!

For mid-career folks with a higher income, the Roth 401(k) is also pretty much the only way to take advantage of the after-tax feature of a Roth IRA. Before the Roth 401(k), you could only get a Roth IRA, which maxes out at $5,000 per year and is only available to people who make under $110,000 annually.

Final Notes

  • If your company does offer a match, the match goes into a 401(k), not the Roth 401(k).
  • You can roll the Roth 401(k) into a Roth IRA at any time, i.e., if you change employers, or to avoid making required withdrawals after age 70 or so.
  • There’s a Social Security benefit to the Roth 401(k), which is that the money here isn’t going to be taxed as income in the future.

What I’m Going To Do

I’m going to start out by giving the Roth 401(k) a (much) weightier percentage of my contributions. Given that I will probably end up in a higher tax bracket in the future, it’s definitely the better investment for a young person.  Furthermore, the absence of a company match (aka free money) gives me less incentive to put money into the company’s 401(k) plan, especially in this market.

I found an article saying that the Roth 401(k) is set to expire in 2010, unless Congress still looks favorably upon it. Not sure where this is headed, but don’t feel like looking into it.  Bottom line: take advantage of it while it’s there.

After the first couple months of savings-ness, I might also open a Roth IRA. I haven’t found a single article that hasn’t advocated for it as an investing essential for young people. Money from a Roth IRA is more liquid than these 401(k)s, and can be taken out tax-free for new family things like college, a house or even your kids’ education.

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