What is the difference?
While many people know that there are two different types of 401(k) plans, the Roth 401(k) and the regular or traditional 401(k), deciding which is be the best for you is not a simple question.
The two types of plans are effectively mirror images of each other with essentially opposite tax treatments. With a regular 401(k) you invest pre-tax dollars and pay taxes at withdrawal, while with a Roth 401(k) you invest after-tax dollars and pay no tax when you make your withdrawal.
Will income tax rates be better when I retire?
You can do innumerable calculations with different assumptions of how much you’ll contribute, what interest rate could you earn between now and withdrawal, and how much your tax savings would be now (if you’re taking the traditional approach) vs. how much it would be at retirement (if you opt for the Roth approach). The problem is, no one has even a hint of what will happen to income tax rates between now and when you’ll be making your withdrawals. And that’s the key to the puzzle – will you pay more in taxes now or when you retire.
Some would say that income taxes are almost always going to increase – but from a historiical perspective that’s not always been the case. In fact, the highest income tax rates in the history of the United States (not counting during WW2) were 77% in 1964 and 70% in 1981, both of those much higher than what we see today.
How much can I deposit? Is it the same for both kinds?
There is one other factor that we would suggest you take into account, one that most of the “Roth vs. Traditional” analyses don’t consider. That point is that since you have to pay income tax on your earnings before you make your Roth contribution, some people may find that it’s harder to make the full maximum contribution with a Roth than with a traditional plan. If you’re in a 25% tax bracket you’d have to earn 25% more to have enough after tax dollars left to make that full contribution and that may be an important point for some.
Why not do a little of each?
Perhaps the best answer is to diversify. Almost all financial advisors suggest that the best investment portfolio should be significantly diversified. That means that you should probably spread your funds over different types of investments, different investment advisors, perhaps over different geographical regions – domestic vs.international, and over different time frames until maturity.
Why not go for the best of both worlds? If you diversify your 401(k) between both types, Roth and traditional, and then whichever way the income tax balancing scale swings, you’ll be prepared. |
