Roth Vs. Traditional 401(k) Plan: How To Choose

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Tax relief today? Or would you prefer tax relief tomorrow? That's the choice an increasing number of workers face.

According to Fidelity, 42% of the retirement plans run by the company offer a Roth option. That's up from only 17% five years ago.

So, many workers now can choose between a traditional 401(k) and a Roth version. The same is true for similar plans such as 403(b)s. The choice boils down to which version gives you the better tax deal in retirement.

Often, the younger you are, the more likely you should put your money into a Roth plan. Another way to decide: If your tax rate will stay the same or rise in retirement, a Roth is better.

Here's why. With a traditional 401(k), you get a break upfront. Contributions aren't taxed.

Young workers might be in a relatively low tax bracket. With a Roth, they avoid taxes at a higher rate in retirement.

Say a hypothetical Art Lee is age 35. Lee's wife stays home with their kids. This couple is in the 25% tax bracket this year. If he contributes the maximum $17,500 this year, he'd save $4,375.

Suppose Lee earns 8% a year on that $17,500. In a tax-deferred retirement plan, his money would grow to about $280,000 in 36 years.

Under current law, Lee will be required to take some distributions from his plan then. The Lees might be in a 35% tax bracket then.

Say the IRS absorbs 35% of the distributions Lee takes from his account. His $280,000 would really be worth only $182,000, after tax: 65% of $280,000. The math is even less appealing for workers now in a 15% bracket.

Better In A Roth?

Lee may be better off in a Roth 401(k) instead. He'll get no upfront tax deduction, so the Lees will give up $4,375 in current cash flow.

But Roth 401(k) money would come out tax-free, after five years and after age 59-1/2. By age 71, Lee might be able to withdraw $280,000, tax-free, from 36 years of compounding of this year's $17,500 contribution.

That will be true even if future income tax rates are much higher than today's rates, as many expect.

But Roth 401(k) plans may not work for everyone. Suppose Ann Hunt is age 56, planning to retire in six years. Ann and her husband are in the 39.6% tax bracket.

For those 50 and older, this year's maximum 401(k) contribution is $23,000. So Hunt can put that much into her 401(k) this year and save $9,108 in tax: 39.6% of $23,000.

Dropping Brackets

The Hunts project their income will fall when they retire in six years, dropping them into the 28% tax bracket.

Then, Hunt will owe only $6,440 for every $23,000 she withdraws. Deferring tax in a traditional 401(k) will put her ahead of the game. Her husband can do the same if he's in a 401(k) plan, doubling the couple's tax benefits.

On the other hand, the Hunts might not be sure of their future tax bracket. And Lee might not be willing to forgo $4,375 of tax savings this year.

If you're in such a situation, consider splitting your contribution between traditional and Roth 401(k) accounts. You can calculate how much tax you want to save now and how much you want to invest for tax-free retirement income.

Likewise, the Hunts can divide their $23,000 401(k) contributions, too. They'll get some current tax reduction and some money they can tap, tax-free, even if they retire in a steep tax bracket.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Mutual Funds

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