Should I contribute to a traditional or Roth 401(k)?

@Money July 15, 2011: 11:47 AM ET

NEW YORK (Money) -- I'm just starting out in my career and I'm trying to decide how to divide my contributions between my company's regular 401(k) plan and its Roth 401(k). I've heard that I'm better off putting money into the Roth because I'm probably in the lowest tax bracket I'll ever be in. If I contribute 10% of my pay, should I just put 5% in each? Or should I put it all in the Roth 401(k) and switch to a regular 401(k) later in my career as my tax burden rises? -- Derek, Kansas City, Mo.

In theory, as a young person you are likely to pay the lowest tax rates early on in your career when your income is probably smallest.

On balance, that argues for contributing to a Roth 401(k) and paying the tax on the contribution now at a low tax rate and sidestepping a higher rate later on rather than contributing to a regular 401(k) and paying a higher rate down the road.

But arbitraging tax rates isn't always so neat and clean in the real world. Your income might not grow as much as you think. And tax rates can, and do, change frequently. So it's hard to predict where they might be decades from now.

What really counts in the traditional-versus-Roth 401(k) calculation is the difference between the tax rate you face at the time you contribute to your 401(k) and the rate you pay when you withdraw the money in retirement. (Or, more accurately, "rates" you may pay as you might not face the same rate every year.).

How much diversification do you really need?

That's not just a matter of the tax brackets that prevail when you are retired, but also the size of your retirement income. Keep in mind that even if the brackets have gone up, you could still face the same or even lower tax rate if your income has fallen off enough after you retire.

So while I think it makes sense for you to favor the Roth 401(k), I wouldn't fund the Roth exclusively. I'd also put some dough into the traditional 401(k), too -- if for no other reason than to hedge my bets about future tax rates. (For more on this concept of tax diversification, click here.)

I can't give you a formula or rule of thumb for divvying up your 401(k) contribution. It's really more a matter of how confident you feel about your likely tax situation in retirement.

If you're on the fence -- with no strong opinion either way -- then you might try to keep roughly equal amounts in both accounts. However, the more you feel that, one way or another, you'll be facing higher tax rates when you begin drawing money from your retirement accounts, the more you should lean toward the Roth 401(k).

For example, if you're really convinced you'll be hit with a higher tax rate then you could shoot for a ratio like 70% Roth 401(k) and 30% traditional. If, on the other hand, you think the opposite is more likely to be true -- that is, you'll end up in a lower tax bracket -- then you might reverse the percentages.

Should I convert my traditional IRA to a Roth?

These aren't carved-in-stone rules. They're just rough guidelines that you can adjust based on your own preferences.

There are also a few other things you'll want to consider. The more you favor the Roth, the less of your income will be sheltered from taxes today and, thus, the higher your current tax bill.

This calculator can show you the effect different levels of contributions to traditional and Roth 401(k)s will have on your tax tab and take-home pay.

Also, remember that contributing to a traditional 401(k) lowers your adjusted gross income. So to the extent you contribute to a Roth 401(k) instead, your adjusted gross income will be higher, which may affect your ability to take deductions pegged to adjusted gross income, such as medical and miscellaneous expenses. It may even determine whether you can do a traditional or Roth IRA.

And don't forget that if your employer matches any part of your 401(k) contribution, then even if you contribute solely to the Roth 401(k), you will still end up with money in the traditional. That's because employers are required to put all matching funds in a traditional 401(k).

So say you earn $40,000 and contribute 10% of your salary, or $4,000, and divide it equally between your traditional and Roth 401(k) and your employer matches 50% of that amount, or $2,000. Over the course of a year, you would actually end up with $2,000 going into the Roth, while your traditional IRA would get double that amount, or $4,000 (your $2,000, plus your employer's $2,000 match).

Be sure to take any employer match like this into account when divvying up your contribution. Don't get too obsessed about this, though, as there's no way to accurately predict the tax rate you'll face in just a few years -- let alone 30 or more years.

Besides, you can always make adjustments later on by contributing more to one account or another or, assuming you qualify, contributing to a traditional or Roth IRA.

You also have the option of converting dollars in a regular IRA or 401(k) to a Roth IRA and, possibly, do an "in-plan" rollover, from a traditional 401(k) to a Roth 401(k).

At the end of the day, your retirement security will depend more on whether you consistently sock away that 10% of your salary year after year throughout your career than how you divvy it up between traditional and Roth accounts. To top of page

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