Monday, June 15, 2009

Traditional 401k vs Roth 401k

There are a lot of factors to consider when choosing whether or not to contribute your money twords a Traditional or Roth 401k if your company offers both. Here are some things to consider when comparing the two:

  • What is the income you are making now vs the amount that you want when you retire?
  • Does your company match?
  • Do you think taxes will be higher or lower for you when you retire?
  • Will you max out the 401k?
  • When do you want to retire?

The key differance between a Traditional 401k and a Roth 401k is that in a Traditional you do not pay taxes now, rather you pay taxes when you take the money out. On the other hand the Roth 401k is different in the sense that you pay taxes now, but when you take the money out you don't pay taxes.

If you assume no company match and the tax rate today is going to be the same as when you retire, the two are generally considered a wash. This is actually untrue, the reason is when you defer your Traditional 401k contrabitions they are deferred at the highest taxable bracket that you are currently in. When you take out the money after you retire you re-walk the marginal tax brackets, this means that the money is actually taxed at a lower taxable rate when you take it out. Therefore dollar for dollar the Traditional 401k makes more sense assuming equivalent tax rates.

When talking about where tax rates are now and where they will be when you retire this depends on you as a individual as much as it does the bureaucrats in DC. If you are a lowly slug in the food chain right now, and you retire as a CEO it is clear that you are on a lower tax bracket now as the lowly slug then you will ever be in your entire life, so in this case the Roth makes sense. It also depends on what you think the cronies on capital hill will do with the laws between now and when you retire. Many assume that taxes will be higher then they are now, and therefore argue that the Roth 401k is advantageous. I argue that it is difficult to gauge either way, if you take historical trends into account its really hard to pin down where taxes will go.

If your company offers a match generally the match is better in Traditional because the match is made as a Traditional 401k, so you have to pay taxes on the match when you take it out. Since the amount of match that you get when you contribute to a Roth is effectively lower you are better positioned when you apply your match to a Traditional 401k.

If you can max out the 16,500 contribution limit, then it always makes sense to go Roth, because you can end up contributing more then with a traditional 401k. The last thing you must consider is when you are planning to retire. Current Traditional 401k law forces you to begin taking out minimum 401k distrabutions at the age of 70 1/2, if you plan on retiring much later say 80, you might want to consider the Roth 401k.

There is nothing to stop you from contributing to both the Traditional and Roth 401k's. As always you must pick an investment strategy that not only you are conferable with, but makes sense for you as well.

UPDATE: In the case of the Roth only a Roth IRA prevents you from having to take the distribution at 70 1/2. So if you want to avoid it you have roll it over to a IRA.

UPDATE 2: The forced distribution age was changed form 59 1/2 to 70 1/2.

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