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A 401(k) versus a Roth 401(k)
A reader asks if he should switch his regular account to a Roth account, or split his contributions.
November 16, 2005: 11:07 AM EST
By Walter Updegrave, CNN/Money contributing columnist

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NEW YORK (CNN/Money) - I'm 28 and contribute 10 percent of my $50,000 salary to my 401(k) and I'm getting a pretty good start towards retirement.

I know that beginning in 2006 employers can begin offering Roth 401(k)s. Should I contribute to them?

--Tim, Boston, Mass.

Before I answer your question, I should point out that the key word here is that employers can begin offering Roth 401(k)s. But according to a recent survey by the Profit Sharing/401(k) Council of America, only 17.4 percent of companies plan to.

If you're not within that fortunate group, you still have the option of contributing to a Roth IRA, provided you meet the eligibility requirements. (For details on those and lots of other good info about Roth IRAs, click here.)

Now let's get to the issue of whether you should take advantage of a Roth 401(k) and, if so, how much you should contribute.

I believe that most people should put at least a portion of their retirement savings in a Roth 401(k) or a Roth IRA or both.

Taxes breaks now and later

True, when you contribute to a Roth, you don't get the immediate tax break that you do with regular 401(k)s and IRAs, which both lower your taxable income when you contribute to them.

With a Roth, you contribute after-tax dollars, or money on which you've already paid tax.

On the other hand, withdrawals from Roths are tax-free. With a regular 401(k) and IRA, you pay tax on both your pre-tax contributions and the earnings when you pull the money out.

So the regular versions give you a tax benefit at the start, the Roth versions give you the benefit at the end.

In a pure economic sense, there's no difference between the two.

What can make one a better deal than the other is if your tax rate changes from the time you make the contribution to when you pull the money out. If you think your tax rate will be higher when you withdraw the funds in retirement than when you contribute, then the Roth is the better deal.

If you think you'll face a lower rate in retirement, then the regular 401(k) is better.

The problem, of course, is that we don't really know whether the tax rate we'll face in the future will be higher or lower than our tax rate at any given time in our career. (Remember, your tax rate is likely to change during your career as your earnings rise or fall.)

And there's always the wild card of what Congress may do. That august body has been known to raise taxes from time to time.

Hedge your bets

Given such uncertainty, I think it's a good idea for most people to hedge their position by contributing to both regular 401(k)s and IRAs and Roth versions, if they're available. Doing both will also give you more flexibility when you're withdrawing money in retirement.

For example, if after retiring, your income in a given year has put you on the threshold of a higher tax bracket, you could switch from pulling money from your regular 401(k) or IRA and instead take tax-free money from your Roth account to avoid a higher tax bill. [For more on the benefits of what I call "tax diversification," click here.

As to how much you should contribute to Roth 401(k)s and IRAs vs. regular 401(k)s and IRAs, alas, I don't know of any way to give you a percentage breakdown.

I think it makes sense for a young person who currently faces a relatively low tax rate but expects his or her income to rise substantially over the course a long career to favor Roth-type accounts. Similarly, if you're older and most of your retirement savings are already in regular 401(k)s and IRAs, then you'll probably want to stash all you can in Roth accounts to even the scale a bit.

Conversely, someone in a higher tax bracket who expects his or her income could fall substantially in retirement thus leading to a lower tax rate in the future should favor the conventional 401(k) and Roth.

Keep in mind too that there is the option of converting a regular IRA or IRA rollover to a Roth later on. For more on that, click here.

But I wouldn't obsess over getting the proportions exactly right. I'd say your goal should be to end up at retirement with enough money in both regular and Roth-type accounts to give yourself a little maneuvering room.

In the end, the single most important thing you can do is to save the money somewhere, whether a 401(k) or IRA, conventional or Roth. If you do that, you'll greatly improve your retirement prospects however all the tax unknowables work out.


Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."

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