Should I contribute to my Roth 401k?Submitted by Castlebar Asset Management on June 18th, 2015
Many employers are offering you the option to contribute to a Roth 401k as part of their 401k plans. This option has been around for about 10 years and is slowly being added to more plans. This has created some confusion on which way you should direct your retirement contributions.
Differences between a traditional 401k and Roth 401k
When you contribute to a traditional 401k it is on a pretax basis. This allow you to lower your taxable income now, but when you withdraw money in retirement it will be taxed at your ordinary income rate at that time. Your contributions to a Roth 401k are made on an after tax basis. This does not provide any tax relief now, but you are able to take distributions tax free in retirement. The same rules apply to both a traditional IRA and Roth IRA.
Which plan is the right one for you?
Roth 401k plans are the preferred option if your income is lower now, and therefore your taxes are lower then they will be in retirement. If your tax rate is expected to be the same or lower in retirement than it makes sense to contribute to a traditional 401k. If you are early in your career a Roth 401k is a good option while your tax rate is low. Forecasting future tax rates in 20, 30 or even 40 years is a difficult proposition. It can be hard to plan without a crystal ball!
Roth 401k's offer some other features that make is different from a traditional 401k. Since Roth’s are after tax you do not have to ever withdraw money. With a traditional 401k you have to take distributions when you turn 70.5, unless you are still working.
Since Roth distributions are tax free this can help with tax planning in retirement. If you every need to withdraw money for a large one-time expense in retirement to pay for a wedding, vacation or other major purchase, taking your distribution from a Roth IRA can keep you from jumping a tax bracket. Taking a large distribution from your traditional 401k or IRA could cause you to bump up a tax bracket.
A Roth 401k also can act as a financial safety net. Since your contributions are made after taxes you are able to withdraw contributions made tax and penalty free. We encourage clients to have an established emergency fund in place, but a Roth 401k can act as a temporary rainy day fund if an unexpected event comes up.
The debate between contributing to a Roth or traditional is important but increasing your contribution to your plan is the most important. You can contribute up to $18,000 (the max in 2015) and this should be your ultimate goal. Increasing your contribution levels each year will have a more meaningful impact on your retirement.
There is no rule of thumb of which way to go on your contribution. You will have to evaluate your income level and tax situation to make your decision. We often suggest a blended approach for clients not in highest tax bracket. This way they can contribute half of their contribution into a Roth and half into a traditional. This will provide you with the short term tax relief of a traditional and the long term benefits of a Roth. You should reevaluate this every few years, particularly as your income starts to grow.
Andrew Comstock, CFA
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.