Should You Choose a Roth 401k or a Regular 401k?
Yesterday I was talking to a friend and he mentioned that his company just started offering the option of investing in Roth 401ks. He was wondering if he should stick with his regular 401k or switch to the new option and we talked about the pros and cons of each for a little bit. Here are my conclusions.
A Roth 401k or 403b is a relatively new retirement vehicle that allows employees to put away contributions on an after-tax basis. The yearly contribution limit is the same as a regular 401k, but the earnings will be tax free. Tax free earnings are very enticing, but as with any financial decision, the best choice for you really depends on your specific situation. For me, I would still go with a regular 401k, and here is why.
1. I expect my tax rate to be lower in retirement - Right now my husband and I are really in our peak earning years and we have a very high tax rate. We only spend 30% of our gross income so if that holds true in retirement we would not need to withdraw that much from our 401k and our taxes would probably be lower than what it is now.
2. A regular 401k reduces my adjusted gross income - Even though you don't think about your adjusted gross income until you file your taxes, it actually affects other parts of your financial health. For example, the recent tax rebates were given in full to singles with an adjusted gross income of $75000. If you made more money than that your rebate would be reduced. However, if you made $90500 and maxed out a regular 401k, your adjusted gross income would be $75000 and you would still benefit from a full stimulus check.
3. It is harder to max out a Roth 401k - Right now my husband and I regularly contribute 17% to our regular 401k and we still have not totally maxed it out. If we had to contribute the same amount to a Roth 401k our take home checks would be a lot smaller. Psychologically, investing into a Roth 401k is just more painful than filling up a regular 401k because of the tax bite.
Those are my personal reasons for choosing a regular 401k, but there are many good reasons for choosing a Roth 401k.
1. If you expect to pay more taxes in retirement - The Roth 401k may be a good idea if you are not being taxed that much right now. However, I would still prefer a Roth IRA over a Roth 401k in this situation because you have more freedom in choosing your investments in an IRA. If you do not qualify for a Roth IRA for income reasons, the Roth 401k is a good bet if you expect your tax rate to increase.
2. If you expect to make a lot more money in your Roth plan - If you think that your investments in a Roth 401k is vastly superior than your regular 401k and you could make a lot more money, then the Roth 401k is probably a better idea since your gains will not be taxed.
3. If you expect to collect a significant Social Security check - Withdrawals from Roth accounts do not count towards your income in determining whether or not you pay taxes on Social Security. Mark Cussen explains taxable Social Security income here.
4. A Roth 401k can be rolled over to a Roth IRA easily - You are required to withdraw from all 401ks and traditional IRAs on April 1st following the date you turn 70.5 years old. However, if you turned your Roth 401k into a Roth IRA you do not have that requirement so you could let your money grow longer.
Ultimately, I think having both taxable and non-taxable accounts in retirement is a good idea. You could withdraw from the taxable accounts when you know your tax rate will be low, and then you could withdraw from the non-taxable accounts when you have huge expenses. Having that flexibility is useful because you never know if Roth accounts will stay tax free forever. At least with the regular 401k accounts you know your taxes are already deferred. So even though I do not have a Roth 401k, I faithfully contribute to my Roth IRA.
Has your employer started to offer the Roth 401k? What was your choice and why?
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