Do you expect tax rates to be higher when you retire than they are right now? Do you think you will be earning more at retirement than you do today?
If you’ve answered yes, you should probably opt for a Roth 401(k) if your employer offers one.
The difference between Roth and traditional 401(k)s isn’t particularly complicated, observes Certified Financial Planner Todd Rustman, the president of GR Capital Asset Management LLC in Newport Beach, Calif. It boils down to this, he says:
- With a traditional 401(k), contributions are made up of pre-tax dollars, the account grows on a tax-deferred basis and you pay tax on the account when you withdraw the money. That can take place as early as age 59 1/2, or as late as age 70 1/2.
- With a Roth 401(k), what goes into the account are after-tax dollars. Your contributions will be taxed at current rates, for the years when contributions are made, and when you take the money, again, no earlier than age 59 1/2 with a required minimum distribution by 70 1/2, all of the money comes out tax-free.
According to employee benefits consultant Hewitt Associates, 29% of companies currently offer a Roth 401(k) to their employees, up from only 19% in 2008. This is according to responses Hewitt received from 146 employers last November and December.
Among those companies that do not currently offer a Roth 401(k) alongside a traditional 401(k) option, 12% said they are very likely to do so in 2009, Hewitt says, adding that where companies still do not offer a Roth, lack of evidence of significant employee usage has been the main obstacle.
Given its advantages to younger workers in particular, the problem most likely comes down to how well workers understand the Roth option, first launched in early 2006.
As Hewitt explains in its recent report, entitled “Hot Topics in Retirement,” participants who believe they are in a lower tax bracket now than they will be at the time they retire—which is generally the case for younger employees, as well as many others—may find Roth 401(k) accounts to be advantageous.
People should also ask themselves “Will taxes be higher now or when I retire?” says Rustman.
While the question requires some guessing, the adviser says, “We’re probably seeing lower tax rates now relative to what we’ll probably see in the future,” given the Obama Administration’s plans to stimulate the economy.
Currently, of course, the nation is anticipating a round of tax cuts, particularly for the middle class, but “I think what we’re doing is kicking the can down the road and postponing the pain, so we’ll be paying higher taxes when we can handle it,” Rustman says.
Reducing taxes now or later? Essentially, Rustman says, “You can pay taxes now or not pay and guess later, during retirement." Those 401(k) participants who decide to "take the hit now," paying taxable dollars into their Roth 401(k)s and treating plan balances with tax-free growth during their working years and in retirement may sleep better at night, he believes.
On the other hand, there are clearly people who will be interested in reducing their tax rate now, when the economy is suffering, layoffs are rampant and credit is scarce. Someone making $150,000 a year putting a large portion of their salary into a traditional 401(k)—the maximum permitted level this year is $16,500 or $22,000 for those 50 and up—could ratchet down their tax bracket rather significantly, for instance.
“These are very personal questions,” Rustman explains. What’s important is to understand what the options are and how they pertain to your own situation.