When in Doubt, Balance it Out

As more and more of the onus of saving for retirement falls on employees, more and more employers will look for ways to enhance their retirement savings plans.  One of the emerging plan features that many employers are adopting is the addition of a Roth option in their 401(k) plan.  If and when an employer adds this option, it seems inevitable that employees will immediately ask “which option should I use?”  To help shed some light on this basic question, here are some things to consider:

If you think your income taxes will be higher today

If you are an employee in your peak earning years, or are getting close to retirement and anticipate not needing nearly as much income in retirement as you currently make, then chances are your income taxes will be higher today and lower in retirement.  If that is in fact the case, then you should consider contributing to the traditional 401(k).  As you probably know, contributions to a traditional 401(k) are tax deferred, so instead of paying income taxes on your contributions at today’s income tax rates, you simply postpone the income taxes until you begin receiving the money in retirement; presumably when your income tax rates are lower.

If you think your income taxes will be higher in retirement

If you are early in your career, or like me have the benefit of a high number of tax exemptions, credits, and deductions (my wife and I have four children under the age of 17, so that’s four exemptions, four child tax credits, and with the addition of a mortgage, a healthy tax deduction) then the idea of paying income taxes on your contributions today may not sound like such a bad idea.  After all, the kids don’t stay young forever, and eventually I’d like to get the house paid off.  When I do, the traditional 401(k) may start to make more sense, but until then, employees in situations similar to mine may prefer to contribute to the Roth 401(k) so that they can pay income taxes on the contributions today (at their assumed lower rate) for the benefit of tax-free income in retirement.

If you have no idea when your income taxes will be higher

Employees that are not sure when their income tax rates will be higher may benefit from contributing equally to BOTH a traditional and Roth 401(k) so that they have BOTH tax-deferred and tax-free sources of income in retirement.  This is an example of diversifying your tax strategy.  For employees that are eligible for employer contributions, you may need to contribute more to the Roth 401(k) in order to equalize the contributions.  That’s because your employer’s contribution, by default, must go into the tax-deferred side of the account.  Here’s an example:

Let’s say your employer matches 100% of your contributions up to 6%.  Any contributions you make up to 6% should go into the Roth account since your employer’s contribution will be made into the tax-deferred side (regardless of where your contributions go).  That way you have equal contributions made to both the traditional or Roth side of the account.

But what if you plan to contribute more than 6%, say 10%?  In this example, you would want to contribute 8% to the Roth and 2% to the traditional.  When your 2% traditional contribution is added to your employer’s 6% contribution, you have a total traditional contribution of 8% which would balance your 8% Roth contribution.

Just remember, unlike traditional contributions, Roth contributions are included as taxable income at the end of the year.  Taxpayers that ordinarily receive a tax refund may experience a decrease, or even possibly owe money, once they start contributing to a Roth account.  Be sure to adjust your tax withholdings (see IRS Withholding Calculator) on your W-4 when you begin making Roth contributions

There’s a lot that can change between now and retirement, so to prepare for possible changes in your income tax rates, consider the advantages of a Roth 401(k). 🙂

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