49

I just graduated, and I'm starting a new job soon. My employer has pretty good policy for matching 401(k) contributions, so I want to invest as much as possible, especially during this first year.

My question is: should I invest in a traditional 401(k), a Roth 401(k), or some combination of the two? On the one hand, tax rates may be much higher when I retire, and I might be in a higher tax bracket, so a Roth 401(k) would be good. On the other hand, I might be in a lower tax bracket when I retire, so a traditional 401(k) might be better. It's hard to know where I will stand in 30 years.

Is this the same trade-off as with a traditional / Roth IRA, or is there any other tax difference I should know about?

45

I would go for the Roth for the reasons already described by JoeTaxpayer and JohnFx. Furthermore, there are two additional things I'd like to point out:

First, income tax rates in the U.S. may, in general, rise in the future. If tax rates are expected to rise, then it makes sense to pay the tax now and not later, even if your own income level were otherwise unchanged. While guessing what tax rates might be in retirement does amount to speculation, I suggest there's little chance of income tax rates remaining low in the U.S., with continuing large budget deficits each year.

Second, even when you select the Roth option for 100% of your 401(k) contributions, your employer's matching contributions are still made on a pre-tax basis and will be accounted for in a pre-tax portion of the account! This may make a decision to go 100% Roth easier, considering you'll have some pre-tax dollars as a hedge in case rates or your tax bracket end up actually lower in retirement.

Below is a supporting reference for that second point, from IRS Publication 4530 (PDF), a pamphlet called "Designated Roth Accounts under a 401(k) or 403(b) Plan". Here's the relevant excerpt:

Q. Can my employer make matching contributions on my designated Roth contributions? And, can the matching contributions be allocated to my designated Roth account?

A. Yes. Your employer can make matching contributions on your designated Roth contributions. However, only an employee’s designated Roth contributions can be allocated to designated Roth accounts. The matching contributions made on account of designated Roth contributions must be allocated to a pre-tax account, just as matching contributions are on traditional, pre-tax elective contributions.
[...]

The remainder of the pamphlet is worth reading, too.

  • 2
    +1 I was going to type exactly this. I visited a financial advisor and this was his remark. – MrChrister May 9 '10 at 16:23
  • These are both excellent points. With the U.S. deficit as it is, it's hard to imagine a future without higher taxes. I also didn't know that matching contributions were made on a pretax basis. Very interesting. – Jay May 9 '10 at 17:31
  • Thank you both. I've added a supporting reference for my second point, since it isn't commonly known to those without a plan yet. – Chris W. Rea May 9 '10 at 17:41
17

A Roth IRA should also be part of your plan. Depending on how much room is in your budget for retirement saving after you have maxed out the employer match on your 401k, you should max out the $5000 annual Roth IRA contribution.

The chief advantage to a Roth IRA over any other retirement plan, is the ability to withdraw the principal at any date without incurring tax penalties. Cashing out retirement plans is still something you want to avoid, but the Roth IRA can be a lifesaver during a prolonged job loss, return for graduate school, or overwhelming need for down payment on a house (You should buy long term disability insurance so I left illness and accident off that list).

Individual Retirement Accounts at discount brokerages like Vanguard, eTrade, Scottrade, etc. often give funds with you lower expense ratios and the whole market of options not available in most corporate 401ks. Do the homework on the funds available in your employers plans, and be sure to weight your 401k to the strongest performing funds with the lowest expense ratios, then weight your IRAs towards sectors where your 401k offerings are weak.

In general, the biggest advantages to employer plans are employer matching, higher contribution limits, and possibly group buying power yielding lower institutional expense ratios on some funds. IRA's are all about personal freedom and asset options. There are also advantages to having an existing Roth IRA so it can mature sooner.

  • 2
    $5,500 now I think, as of 2013. – Jason Aug 16 '13 at 19:34
  • 1
    $6,000 now I think, as of 2019 – pants Dec 15 '18 at 18:32
13

First, congrats on graduating and getting a job. Great to hear. I first need to ask you, do you understand the difference between average tax rate and marginal rate? Fairmark gives a great overview of this. Now, not knowing the details of your pay or marital status, I'd think the chance is that you'd be in a relatively low bracket. New hires, regardless of their field, are likely to earn more 10 years hence. That would have me lean towards the Roth today, and watch your bracket, using pretax deposits at some point in the future.

My article, The 15% Solution, goes into further detail on this strategy.

  • 3
    Thank you for the link. It looks like marginal rate is the fraction of the last dollar earned, while average rate is the fraction of overall income paid in tax (correct me if I'm wrong). So Roth contributions would be at my current marginal rate rather than my marginal rate at retirement? – Jay May 8 '10 at 23:18
  • 2
    Exactly. You can manipulate using pre (Roth) or post (Trad 401/IRA) tax dollars to pay at the projected lower rate. Remember, too, there are many situations that can impact your bracket over the course of your life. A marriage, a spouse staying home to raise the child, a lost job, a disability, going back to school. Those are times to plan for a partial conversion. – JTP - Apologise to Monica May 9 '10 at 22:39
1

I think you are asking yourself the right question about what tax bracket you will be in when you will retire.

A couple of points to bear in mind.

First have a look at a US tax table e.g https://turbotax.intuit.com/tax-tools/tax-tips/IRS-Tax-Return/2014-Federal-Tax-Rate-Schedules/INF12044.html

The takeaway is that if you reduce your taxable income in any year; the savings to you depends on which part of the schedule this reduction applies. [otherwise known as the marginal tax rate].

So the follow-on point is when you retire, if you are smart, you will match your income to your expenses so that your income is as small as possible and thus your tax burden is as small as possible. You don't need income that you will invest in retirement.

So if your kids are in college, and assuming you own your own house [maybe by downsizing] by then, how much income will you really need? Going further, ask yourself, what will be the marginal tax rate for the tax savings you will realize by not paying taxes at this time [as you would in a traditional IRA].

So if you are making more than that now, and you marginal rate is higher, you should offset this in your calculations to the perceived advantages of a Roth.

So hypothetically, I believe that an appropriate income for myself in retirement is say $70,000. So if I get $10K in tax-free income, the realized savings on taxes is 25%, or $2500; as this is the marginal tax rate.

Not let's say I am currently earning my money in a higher tax bracket; say I make $110K a year. Reducing my tax burden by $10K confers to me a realized tax savings of 28%, or $2800, based on the marginal tax table.

So whether or not to use a Roth or traditional IRA should in some sense be driven by forecasting your income in retirement, as compared with your current income, from a marginal tax rate perspective.

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