With a traditional 401k plan, you contribute pre-tax dollars, allowing you to lower your taxable income and reduce your tax liability. Some employers offer a Roth 401k as well as a traditional 401k. With a Roth 401k, you contribute after-tax dollars instead. That means you do not get the up-front tax reduction. What you get instead is the ability to withdraw that money tax-free in retirement. The appropriate choice of plans depends on a number of factors, including your tax situation, your income and where you think tax rates are headed.
Run the Numbers
The availability of tax preparation software packages and online tax preparation programs makes it easy to run the numbers to determine how much giving up the tax requirements of your current 401k will impact you. Fill in as much income information as you can, and when you get to the question about 401k programs, run the numbers with both a traditional and Roth 401k. Look at your tax liability with each plan to determine how much income tax savings you will lose if you decide to invest in your 401k with post-tax dollars instead of pre-tax dollars.
Your current level of earnings determines your tax bracket and the value of investing in your 401k with pre-tax dollars. If you are in a low tax bracket, the value of those pre-tax 401k contributions is diminished. But if you are in a high tax bracket, each dollar you invest in a pre-tax 401k gives you a significant break on your taxes. You might want to invest in a Roth 401k when you are young, because you will have plenty of time for that money to grow and compound. As you get older and start earning more money, you can reevaluate the value of investing in your 401k with pre-tax dollars.
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The amount you have invested in other areas also can impact the relative value of the traditional vs. Roth 401k option. If you have a large nest egg already built up for retirement, your income in retirement could be the same, or even greater, when you retire than it is now. That means you could be in a higher tax bracket when you retire, and that could make a Roth 401k that much more valuable. Taking the time to evaluate the nest egg you already have and the one you plan to build helps you make a prudent decision.
Future tax rates will play a major role in the value of a Roth 401k compared with a traditional 401k. It is impossible to know the precise direction of future tax rates, but you can look at the present for some clues to the future. High deficits and high levels of national debt suggest possible higher taxes in the future. If you believe taxes are likely to be higher in the future, you might want to lean more toward a Roth 401k, because that plan allows you to withdraw money tax-free when you retire.
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