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