Roth 401(K) or Traditional 401(K): Which One Is Better for You?

A few years ago, my wife’s employer started to offer Roth 401(K) together with the traditional, pre-tax 401(K) plan. At that time we decided to continue funding the pre-tax 401(K) account and not contribute to the Roth account for the same reason I used to not covert existing Traditional IRA accounts into Roth. As you know, the biggest difference between a Roth 401(K) account and a Traditional 401(K) account is the former is funded with after-tax money while the latter is usually pre-tax up to a limit set by the IRA (the contribution limit for 401(K) is $17,500 in 2013). This means that, like Roth IRA, earnings in Roth 401(K) will also be tax free, as long as the distribution is made at least 5 years after the first contribution and the owner of the account is at least 59.5 years old.

The biggest advantage of a Roth 401(K) is that earnings will not be taxed, which is also precisely the reason I decided to convert our new Traditional IRA accounts into Roth. But what has prevented us from contributing to Roth 401(K) when it became available was the consideration of whether to pay taxes now or in the future. This is not an issue when choosing between Traditional IRA and Roth IRA because we can only make after-tax contributions. It makes no difference on our current tax situation whether to Traditional or to Roth. However, since earnings in Roth IRA are also not taxed in the future either, the choice is quite obvious. In the case of Roth and Traditional 401(K), tax comes into play as the former is post-tax and the latter is pre-tax. By contributing into pre-tax 401(K) plans, we can lower our current Adjusted Gross Income (AGI) by $35,000 per year if we max out, which we will do, and that will in turn reduce our tax liability. If on the other hand, we choose Roth 401(K), then our tax bill will go up. Even though the increased income may not be enough to push us into the next tax bracket, we will pay more taxes now for sure, in exchange for not paying taxes late in the future. The debate is whether to pay taxes now or in the future.

There’s obviously no way for us to know what the tax rates will be likely 20 or 30 years from now, so our deliberation was based entirely on assumptions. As I mentioned earlier, at the time when we retire, our sources of income will mainly come from 1) Social Security; 2) 401(K)s; 3) IRAs; and 4) other savings in non-retirement accounts. Except distributions from Roth IRAs, which accounts for only a small portion of our retirement savings, distributions from other sources will be taxed as regular income later. Even though we have been saving quite aggressively, my guess is that when we retire, our income will be lower than our salaries, which, hopefully, will continue to grow as long as we work. If this will be the case, then it makes sense to defer paying taxes to a later time by contributing pre-tax dollars to Traditional 401(K), especially that now we are able to fund Roth IRAs.

While the consideration of taxes is valid for us, Roth 401(K) is still quite attractive for 1) tax free distributions will give us more flexibility in the future (after-tax dollars are better than pre-tax dollars?); 2) Roth 401(K) can be rolled over into Roth IRA upon termination of employment, but not the Traditional 401(K).
This year, my employer switched from its self-managed 401(K) plan to the plan managed by Fidelity and one new feature came with the switch is Roth 401(K). As a part of the changes I made in 2013 on how we invest, I decided to also contribute to Roth 401(K). I didn’t make the full switch from Traditional to Roth 401(K), but only a third of the total amount allowed this year. That will exceed the Roth IRA limit. By participating in both Roth and Traditional 401(K), I won’t increase our taxable income too much now and get the benefit of tax free distributions in the future.

Are you also using Roth 401(K)? Yes or no, what are your reasons of using or not using it?

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