Question: My company just added a Roth 401(k) investment option to our retirement plan. I am currently saving 6 percent of my salary in my 401(k), with a 3 percent match from my company. (This is the maximum match.) Now that there is an option to invest in the Roth, with the same match available, I am not sure how to adjust my investments. I don’t have any other retirement savings besides my 401(k). I have talked this over with a few of my friends and none of them seems to know the answer, either. Thanks for your help! Priscilla, Greenville, N.C.
Answer: More companies must be adding the Roth 401(k) option to their retirement plans. We’ve been getting a number of questions about it recently.
The most important decision is to participate in your company’s retirement savings plan and to take full advantage of the company match. You do both. I’m agnostic after that.
We know it’s critical to save for your old age. There isn’t a serious debate about that. But when deciding between the Roth 401(k) and the traditional 401(k), it matters what tax brackets will be 5, 15, 30 years from now? Who knows? Similarly, will your income be higher or lower during retirement? Depending on your career and savings habits, it could go either way.
The aspect of the Roth 401(k) option that intrigues me is tax diversification.
Taxes are the defining difference between a traditional 401(k) and a Roth 401(k). Your contributions to your current 401(k) are made with pretax dollars. You’ll pay your ordinary income tax rate on the savings when it’s withdrawn during retirement. From a strictly tax perspective, the best scenario is a lower tax bracket in retirement.
Contributions into the Roth 401(k) are made with after-tax dollars. The earnings on your investments are tax free at withdrawal. Again, from a tax perspective, the Roth is best if you have a higher tax burden in retirement.
The employer match with the Roth 401(k) is made with pretax dollars. It grows in a segregated account. The match gets taxed at your ordinary income tax rate when the money is withdrawn during retirement.
It seems to me that there is a financial flexibility advantage to having some money in a traditional 401(k) and some in a Roth 401(k) (or a Roth IRA). The different tax treatment of money at withdrawal adds to your financial options. Tax diversification pays.
The 2012 contribution limit for a 401(k) is $17,000 ($22,500 if 50 and older). You could continue to contribute the maximum into your current 401(k) and open a Roth on your own ($5,000 limit; $6,000 if 50 and over). Or, if your employer allows it, you might consider splitting your contributions, putting some into both. (Your limit on 401(k) contributions is $17,000. You can divide that sum between the two choices; you can’t put $17,000 into each.)
One last point: The decision to participate in the Roth 401(k) is an easier one for for highly paid employees. They make too much money to open up a Roth IRA. The Roth 401(k) is a way for highly compensated employees to enjoy tax-free withdrawal at retirement. You can read a good — and slightly more positive — take on the Roth 401(k) here.
There’s a lot happening in the world. Through it all, Marketplace is here for you.
You rely on Marketplace to break down the world’s events and tell you how it affects you in a fact-based, approachable way. We rely on your financial support to keep making that possible.
Your donation today powers the independent journalism that you rely on. For just $5/month, you can help sustain Marketplace so we can keep reporting on the things that matter to you.
