Tax season has started in earnest, and some clients are asking whether or not they should switch their 401(k) accounts at work to the new Roth 401(k). They are hoping, I’m sure, for a simple answer. However, “It’s simple” is one thing you’ll almost never hear me say about a tax issue.
The Roth 401(k) is new for 2006 and reportedly is being offered or seriously considered by about 30 percent of the employers who have traditional 401(k) plans. If you are given the choice, should you stick with the traditional plan or switch to a Roth?
Sometimes – and this seems to be one of those times – I conclude that “fence sitting” is the best strategy.
The new Roth 401(k) offers a new flavor of retirement savings. With it, employees can save for retirement with no tax deduction at the time of savings, no tax on the growth in the account and no tax due at the time of withdrawal.
In the standard 401(k), you get a deduction at the time of savings, and there’s no pay-as-you-go tax on the growth (as there is if you own mutual funds in non-sheltered accounts). But you’ll pay tax on the contributions and the growth when you withdraw the money.
Having this new option is welcome, but making the choice of whether to accept it requires carefully thinking about things (such as future tax rates and brackets) that you cannot possibly know.
When my clients ask me if they should choose a Roth 401(k) or a regular 401(k), the question really requires the same analysis as it does for Roth vs. traditional IRAs. It’s hard to do that analysis without asking big, sweeping questions that tend to go well beyond traditional tax planning and investment planning.
For example, how much do you trust your government to leave the tax system the way it is now? What kind of financial life will you lead when you’re retired?
Of course, in some situations the analysis is fairly straightforward:
- If you are very young or in a very low tax bracket, the Roth option tends to be preferable because you pay the taxes now at low rates and may benefit from tax-free compounding for decades.
- If you are lucky enough to have cash to spare, you would take the Roth option, because it effectively lets you put more money into your sheltered savings.
- If you are currently in a higher tax bracket than you expect to be in retirement, you would lean towards the traditional 401(k), which lets you pay taxes at the lower rate later.
- If you have a very tight budget, you would lean towards the traditional 401(k), because the tax deduction would give you an immediate benefit.
In real life, most real people don’t fit neatly into just one of these theoretical buckets. As a result, they can’t be sure which path is best. Since neither I nor my clients can predict the future, I like to see them set up their retirement accounts for ultimate flexibility.
Fortunately, “fence sitting” can work out pretty well when it comes to retirement planning.
When I’m helping clients, I like it best when they have a balance of both Roth and standard retirement accounts. This lets them draw money out of one account or the other in retirement depending on their tax situation in any given year. In high-tax years, they can take money from the Roth. In lower-tax years they can draw more from the non-Roth account.
Because of the contribution limits to Roth IRAs and their relative youth (first authorized less than a decade ago), most of us have more traditional retirement savings than Roth savings.
This makes me think that a good strategy for many people may be to contribute as much as they can to Roth accounts until their Roth and non-Roth retirement accounts are approximately equal. After that, they could split future contributions evenly.
I have been accused of ducking the question by advocating this “fence sitting” strategy, but I’m not budging from that fence! I believe that the flexibility gained by a 50/50 mix of taxable and non-taxable assets will be terrific for many people when they are retired.
Of course I recommend that each person make this choice based on his or her own circumstances, something that’s best accomplished with the help of a tax advisor.
The magic crystal ball I ordered online is seriously back-ordered. But as soon as I receive it, I’ll be able to give the definitive answer to the question: To Roth or not to Roth? In the meantime, I invite you to join me here on the fence.
For a comparison of Roth and traditional 401(k)s, click here.