We chatted with two young clients on the phone the other day about the best option for their 401(k) plans. They’re married and in their early thirties.
Should they use the Roth 401(k) option available in their company’s plan? Or should they opt for the traditional, deductible 401(k) option?
To give them the right answer, we started by looking at their last tax return to check their tax bracket. Last year, their highest marginal tax rate was 15%, which is low (their taxable income is normally reduced by substantial non-taxable income and deductions).
In their situation, the traditional 401(k) won’t save them a lot of money. Yes, they’ll be able to deduct their contributions, but due to their low tax bracket, that will save them only 15 cents on the dollar.
But here’s where the long-term strategy comes in. In the future, we’re certain their tax bracket is going to be higher, as their careers take off and salaries increase. That makes the Roth 401(k) option more attractive.
They are not getting any deduction now, but they are trading that for a lifetime of tax-free growth. When you’re young, that’s a great deal.
Making the right decision
Does your plan offer the Roth option? Over half of all 401(k) plans offer a Roth alternative, but only about one-fifth of employees are currently taking advantage of it.
Tax bracket. If you’ll be in a lower tax bracket once you stop working, you’re probably better off sticking with the traditional 401(k) choice. If your current bracket is low, and likely to go higher, take advantage of the Roth option now.
Age. All other things being equal, younger workers are better off with the Roth.
But exceptions do apply. For example, even if you’re older, the Roth may be a good option if you’re frozen out of regular Roth IRA accounts due to your higher income, but want to build up your tax-free savings. (The income limits that apply to Roth IRAs do not apply to Roth 401(k) contributions). When we work with clients, we like to diversify their retirement income sources so they can draw from both taxable and non-taxable pots of money and help control taxes. Having a Roth account is a good way to do that.
The right answer? It’s important to look at the Roth versus Traditional 401(k) choice on a case-by-case basis, so ask your CERTIFIED FINANCIAL PLANNER™ advisor for help. The best tip? Whatever your situation, make sure to participate fully in your workplace plan and max your contributions as much as possible. The best way to win is just to get in the game.