At some point, many of us have had to brush up on the difference between two tax-advantaged savings accounts: Roth IRAs and traditional IRAs. Now, those who invest solely through their company's 401(k) plan may want to get up to speed as well.
That's because the number of businesses offering a Roth option for their 401(k) is skyrocketing. According to employee-benefits giant Aon-Hewitt, 50% of organizations now offer Roth plans, up from 11% just six years ago.
While the traditional and Roth versions both offer important tax benefits over other accounts, they have significant differences. Making the right choice now is important for any participant, but particularly for those in their 20s and 30s, who have decades before they'll retire and draw on their funds.
Comparing the Options
An employer-sponsored 401(k) is often the first place Americans go for long-term investing, and it's easy to see why. Companies frequently match all or part of the employee's contribution, so those who opt out are throwing away part of their compensation package.
In a traditional 401(k) plan, workers contribute a percentage of their salary, on a pre-tax basis, to one or more investment choices. Ordinarily, the account holder doesn't have to pay Uncle Sam a penny until retirement, when withdrawals are taxed at the individual's current income tax rate.
The Roth variant is essentially the same concept in reverse. Employees put an after-tax portion of their salary into their investments, but can withdraw the money tax-free in retirement. In other words, the pain is front-loaded.
The big question is this: Is my current tax rate higher or lower than it will be when I retire? If you expect it will be exactly same, the traditional versus Roth choice may not matter much; your nest egg will be identical either way. Here's how the math works for an employee with an effective tax rate of 15% and $5,000 to save.
Traditional 401(k) If she puts the $5,000 into a standard 401(k) plan today and her one-time contribution grows at 7% annually, it will be worth $38,061 in 30 years. If she's still in the same tax bracket at that point, she's left with $32,352 after paying the IRS.
$5,000 x 1.0730 = $38,061 (ending balance) - $5,709 (income tax) = $32, 352 (net withdrawal)
Roth 401(k) Now suppose that she put that same $5,000 portion of her paycheck into a Roth account. She'd pay $750 in taxes up front, leaving her with $4,250 to invest. At a 7% growth rate, her account would grow to $32,352 after 30 years, which she can withdraw tax-free. She ends up in the same place.
$4,250 (after-tax contribution) x 1.0730 = $32,352 (ending balance)
The Difference for Younger Workers
It's rare that younger workers are at the same tax rate now that they'll be when they hit 59 ½, the age when you are eligible to withdraw 401(k) funds without penalty. If you're just a few years into your career, chances are your wages will only go up. And if you're in a low bracket now, the general thinking is to pay the tax now.
Let's say this same employee advanced in her career and climbed to a 30% tax rate by retirement. She'd have cut her tax bill in half by choosing a Roth.
Hedging Your Bet
In many cases, younger employees are paying little, if any, in federal taxes, which makes the Roth a relatively easy choice. But after getting a couple of promotions and moving up to a higher bracket, the answer might not be so clear-cut. It's also worth keeping in mind that no one knows exactly how the tax code will look 15 or 30 years from now, so there's always a chance that one's rate will actually be lower by the time they retire.
Luckily, you don't have to put your entire nest egg in one basket. If company rules allow, you can contribute to standard and Roth 401(k) accounts simultaneously, alleviating the risk that you've picked the wrong type. This can be yet another important way to diversify your portfolio.
Convert to a Roth – or Not?
What if you've been adding money to a regular 401(k) for years, but realize that a Roth is probably a better fit? You may be able to transfer your existing balance into a Roth account. About a quarter of companies that offer a Roth already allow in-plan conversions, and that number is growing quickly.
Converting doesn't always make sense. You have to pay taxes on the contributions and earnings you switch over, a hardship for many entry- and mid-level employees.
One more point: unlike converting to a Roth IRA, moving to a Roth 401(k) is permanent; there's no way to re-characterize the funds back into a traditional account. Unless you're extremely confident that a Roth makes sense – and you have the funds on hand to pay your tax bill – keeping your past contributions right where they are might be your best bet.
The Bottom Line
Both traditional and Roth 401(k) plans offer significant benefits over non-tax-advantaged accounts. If you're new to the workforce and think your tax bracket will probably be higher by the time you retire, contributing to a Roth may provide you with additional upside. When in doubt, check with a qualified financial advisor.