NEW YORK (MainStreet) A fresh graduate starting a first adult-world job can face a raft of unfamiliar issues, from buying a car or getting an apartment to starting the 40- or 50-year process of saving for retirement. Among them: Should you start a 401(k), and, if so, how should you set it up? What's best, a traditional 401(k) or a Roth?
An employer's 401(k) plan allows the employee to contribute a portion of income to a long-term retirement plan, often with a matching contribution from the boss. In a traditional 401(k), contributions are subtracted from taxable income, and there are no annual taxes on investment gains, reducing the employee's annual tax bill. But income tax must be paid on money withdrawn in retirement.
With a Roth, there is no tax deduction on contributions, but all withdrawals the original contributions and investment gains are tax free.
On paper, the pros and cons of each are simple. If your tax rate will be higher in retirement than when you make the contribution, the Roth may be the better choice. You will pay tax at a low rate, such as 15%, on the money used for the contribution to avoid tax at a higher rate, say 35%, when you make withdrawals.
The traditional 401(k) would be better in the opposite case with a high tax bracket when contributing and a low one when withdrawing. You could save a big tax bill upfront and pay only a small one later.
The problem, of course, is you can't know what your tax brackets will be over time. That will depend on how much you earn, what deductions you can claim and how the government sets the tax rates over the decades.
Many people are in their peak earning years in their 50s and assume their income will be lower after they retire. So for them the traditional 401(k) makes sense they avoid tax at a high rate and pay later at a lower one.
But young people just starting out often don't earn very much and pay very little in federal income tax. For them, the tax savings on contributions to a traditional 401(k) are worth little or nothing. Since income and tax rate could well be higher in retirement, the Roth would seem to make sense. You don't get an upfront deduction that has no value anyway, and you avoid taxes on what could be enormous investment gains that build up over the decades.
A key to choosing between the two types of 401(k) is an innocuous piece of paperwork you're likely to do on your first day at work filling out the W-4 form that determines how much of your income is withheld to pay taxes. If it is filled out thoughtfully, you will have neither a tax bill nor a tax refund after you file your return in April, meaning the withdrawals met your tax obligation perfectly.
After filing the form, study your first few paychecks to see what portion of your gross income is going to federal income tax. This does not include the Federal Insurance Contributions Tax, or FICA, that pays for such things as Social Security and Medicare. If your income tax is low say, 15% or less the Roth may be the best choice.
But remember to revisit this question every year throughout your working life. If things go well, your income will get bigger and your tax bracket will rise. At some point it may make sense to contribute to a traditional 401(k) instead of a Roth.
--Written by Jeff Brown for MainStreet