Asset Location

To Roth or Not to Roth in Your 401(k)?

Asset Location

A question we are commonly asked at Index Funds Advisors is whether contributions to a 401(k) plan should be to a traditional or a Roth account. Recall that the former defers taxes until withdrawals begin while the latter takes a tax hit at the beginning and is tax-free afterwards. Contributions to a traditional account are funded with pre-tax dollars while contributions to a Roth account are funded with post-tax dollars. For example, for a worker who is in a 20% tax bracket and desires to have $10,000 go into her 401(k), she would need to use $12,500 of salary to make a Roth contribution while she would only need to use $10,000 of salary to make a traditional contribution. However, if she expects to be in the same tax bracket in her retirement years, then taking the tax hit now can make sense. To see how this works, let's assume that she will retire in 30 years, earn 8% on her investments, and also pay a 20% tax rate in retirement. Here is what we would have:

20% Current Tax Rate with an Expected 20% Tax Rate in Retirement

8% Rate of Return on Investments for a 30-Year Period

 

 

Traditional 401(k)

Roth 401(k)

Amount Invested

$10,000

$10,000

Salary Needed for Investment

$10,000

$12,500

Pre-Tax Value at Retirement

$100,627

$100,627

After-Tax Value at Retirement

$80,502

$100,627

At first blush, the Roth 401(k) looks like a no-brainer. Our hypothetical worker would be giving up only $2,500 today and end up saving $20,125 in future taxes. Of course, if she had chosen to contribute to the traditional 401(k) and invested the $2,500 savings in a taxable account, she would have earned enough to cover the taxes due in retirement. The key point, however, is that she must invest the tax savings and not go spend it on a nice vacation. Since many investors would not have the discipline to do this, the Roth option would be a better choice in these circumstances.

In general, for younger workers who are currently not in a high tax bracket, the Roth option makes sense. Conversely, for older workers currently in a high tax bracket that expect to be in a lower tax bracket in retirement, the traditional 401(k) would be preferred.

Of course, similar considerations apply when deciding what type of IRA to establish and whether or not to convert a traditional IRA or 401(k) to a Roth. The calculator section of ifa.com and the IFA 401(k) Website has many tools such as this Roth vs. Tradtional 401(k) calculator to help you with these types of questions. If you have any questions about your 401(k) or other retirement plan and would like to speak with an IFA Wealth advisor or retirement plan specialist, please call us at 888-643-3133.