Should You Choose a Roth 401k or a Regular 401k?

by Xin Lu on 23 May 2008 15 comments
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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.

ARTICLE CONTINUES BELOW

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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Fred Lee's picture

I can see why it would be nice to access your 401k tax free, but it is a bit of an illusion because you are in fact being taxed on it, just not at the moment of withdrawl. I'm guessing there is a present value of money argument against the Roth, as there is against having too many tax dollars deducted from your weekly paycheck, but there is also a huge psychological element that would seem to encourage it.

As you mentioned, perhaps the best way to go is by diversification, the mantra of retirement specialists. Thanks for the informative article, I'll keep it in mind. 

Guest's picture

Depending on how much you will have and how much you will be withdrawing, you should have 50-50 to 70-30, Roth to traditional. Which gets you tax diversification. It's hard to tell how much our tax rates will be 30 years from now. Plus, it allows the flexibility mentioned in the last paragraph.

However, I must say that I'm not entirely sold or trusting, that the government will never find a way to tax my Roth savings. It does concern me.

Julie Rains's picture

I would opt to get the current tax advantages with the regular 401k as you decided Xin (and focus on trying to invest in both types of accounts as you can) but an advantage of the Roth account (true for IRAs, I am assuming the same is true of the Roth 401k) is that you can withdraw your contributions if you need them at any time without incurring a tax penalty, whereas you'll have penalties on a regular 401k and/or may have to take out a loan if you suddenly need cash and don't have an emergency stash or access to a credit line. 

Philip Brewer's picture

One option that may work out for me is to get both advantages.

I maxed-out my 401(k) while I was working, picking up the tax deduction.

Now that I'm writing full-time, my income is much, much lower.  I'll have to wait to December and then crunch the numbers, but I may be able to convert some of that money into a Roth IRA.  (I rolled my 401(k) into an IRA right after I left.)

I'll have to pay taxes on the money that I convert, but my income is likely to be very low this year--low enough that I can probably convert some money for free.

If it works out, that'll give me the best of both worlds--a tax deduction when my income was high, and then still the tax-free-forever earnings in the Roth.

Of course, the scenario only works if you semi-retire early and have a period during which your income is very low to convert the IRA.  It's not a circumstance that most people aspire to, although I'm thinking that it's working out well for me.

Guest's picture
Diana

I would stick with the traditional 401(k). No one knows what the tax code is going to be like when we retire. While the Roth is a after-tax deduction, it doesn't guarantee that sometime down the road, legislation won't be passed that will tax your withdrawals from the Roth.

Just something to think about.

Guest's picture
Guest

Roth's are post tax money,so if the goverment had something where it actually needed money cause of some kind of shortage of emergency,I could see a tax change forcing traditional IRAs and 401ks to be "called" the goverment a 4 trillion dollor treasure chest of tax money it is owed from traditional IRA/401ks.That is my bigger fear..them changing the tax and calling that due.Why would they ever go after Roths when that is post tax money,when they have 4 trillion dollors that is still owed to them-taxes yet to be paid from these retirement funds.

after the goverment gets the money thats owed to them in taxes -then I would say all bets are off with them going after Roth acocunts.

Guest's picture
Guest

Also, If they do ever pass some kind of tax law that would tax my roth, they would need to give some lead time to which then I can pull ALL my money out of the roth and put in somewhere else.

Xin Lu's picture
Xin Lu

Hey Julie, so I did a little research and apparently the rules of withdrawal on a Roth 401k is different from a Roth IRA.  The rules is that whatever you withdraw is proportional so say $8000 is your contributions and $2000 is your earnings and you withdraw $1000 then $200 is your earnings.  I think before age 59.5 the Roth 401k still carries a penalty on the earnings portion. 

Guest's picture

My company recently started offering the Roth 401K. Then I did some calculations and I realized that my husband and I are going to be really close to the MAGI (Modified Annual Gross Income) limits at which you can no longer contribute to a Roth IRA. The only thing that decreases your MAGI is regular 401K deductions, so I decided to switch back to the regular IRA. This way we'll each be able to contribute $15.5K to our 401Ks, plus $5K to our Roth IRAs (unless we get much higher than expected salary increases)

Guest's picture
kitty

I've been thinking about it since my company introduced Roth 401K this year. For the moment I decided to stay with the regular IRA.

In 2005 and 2006 I was in the same situation as calgirlfinance: the only thing that allowed me to contribute to Roth IRA is my max 401K contribution. In 2007 I would've been in phase-out range, but capital gains from the sale of some portion of my ESPP stock put me over the income limit. I plan to sell some ESPP stock this year as well - too many eggs there - so I'll not be able to contribute to Roth IRA gain. At the same time, max 401K contribution helped me avoid AMT in 2007; hopefully this year as well. Not to mention that once your income gets to a certain amount bad things start to happen like deduction limitations, especially in NY State. On the other hand, if they ever increase the taxes again to where they were 40 years ago, we'd have made a mistake...

That's another consideration: if you live in a high tax state, will you live there after you retire?

Guest's picture
Guest

I don't plan on ever paying tax on my traditional 401(k) plan withdrawals.

Well before I need to start withdrawals, I'm expatriating to another country with minimal residency requirements - and once you've been there 5 years, you can apply for citizenship.

After I get my second passport, it's good bye to U.S. citizenship.

Like most countries other than the U.S., my new home doesn't tax pension or other retirement income, and it doesn't tax any income earned outside the country.

I'll have my 401(k), Social Security, any pension, and *all* the earnings from other investments completely tax free.

There are many countries out there who want first world (U.S, Canadian, European) retired expats for the steady income they bring.

Guest's picture
Guest

Personally, I think the Roth 401(k) still endorses the idea of allowing your employers to control your financial future.

Everyone should have an IRA at least, and the Roth IRA account is by far the best and most efficient tax-sheltered account because it protects against shaky tax brackets in the future.

We all know that America is in debt - heck the author's byline mentions Generation Debt, but not to be confused with Generation Y.

I don't trust congress nor any political advocate in the future, therefore I will go with the Roth IRA until something better reveals itself in the future.

Also, I compared my top 7 favorite Roth IRA Brokeers on my website, so feel free to check out my personal reviews.

Finally, Great article, and honestly whether you choose a 401(k) or IRA, JUST CHOOSE SOMETHING. Don't let paralysis by analysis limit your financial potential in the future.

Guest's picture
Guest

Personally, I think the Roth 401(k) still endorses the idea of allowing your employers to control your financial future.

Everyone should have an IRA at least, and the Roth IRA account is by far the best and most efficient tax-sheltered account because it protects against shaky tax brackets in the future.

We all know that America is in debt - heck the author's byline mentions Generation Debt, but not to be confused with Generation Y.

I don't trust congress nor any political advocate in the future, therefore I will go with the Roth IRA until something better reveals itself in the future.

Also, I compared my top 7 favorite Roth IRA Brokers on my website, so feel free to check out my personal reviews.

Finally, Great article, and honestly whether you choose a 401(k) or IRA, JUST CHOOSE SOMETHING. Don't let paralysis by analysis limit your financial potential in the future.

Guest's picture
jordan7

Found a nice site - easystockalerts.com. It will keep you updated on any breaking news on the stocks you own. See the news before it even appears on the web.

Guest's picture
Renee

There are many pros and cons to converting to a Roth IRA. I just read this awesome blog post on this new Equifax personal finance blog that lists reasons why you should or shouldn't convert. Hope this helps! http://bit.ly/bSUnh8