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Is a Roth 401(k) or 403(b) right for you?
Do you want to potentially reduce income taxes and keep more of what you earn on your investments in your 401(k) or 403(b) plan? If your employer offers Roth contributions in its retirement savings plan, you have the potential to earn income tax-free growth and take income tax-free withdrawals (provided certain requirements are met).1
Are Roth 401(k) or 403(b) plan contributions right for you? Read on to learn if regular pretax 401(k) or 403(b) plan contributions, Roth after-tax 401(k) or 403(b) plan contributions,2 or a combination of both may make sense for you.
What are the differences?
The first key difference between the two contribution types is that a Roth contribution is made with after-tax dollars, while a regular contribution is made with pretax dollars. What this means: Roth contributions, unlike regular contributions, won't reduce your current taxable income. Any earnings on either type of contribution aren't taxed while they remain in the plan account.
The second key difference comes when you start taking withdrawals. For Roth contributions, any earnings are income tax-free if you withdraw them after the fifth tax year from when you made the first contribution and you're age 59½ or over, suffer a disability, or die. For regular 401(k) or 403(b) contributions, both the contributions and any earnings on them are subject to taxes when withdrawn. Withdrawals of either contribution type before age 59½ may be subject to a 10% early withdrawal penalty on the taxable amount.
A few more important facts:
To illustrate the impact of your tax rate on your contributions and withdrawals, let's look at a hypothetical example. Alec, 45, is married, earns $115,000 each year, and can afford to contribute roughly $6,900 (after income taxes) from his take-home pay to his 401(k) per year. He is currently in the 25% federal tax bracket.
Let's see how his future tax rate may affect his retirement savings. Before we do, an important note: Because regular 401(k) contributions are made on a pretax basis, he could actually contribute $9,200 from his pre-tax pay, which is equivalent to $6,900 after taxes ($9,200-$2,300 (taxes at 25%) = $6,900), without seeing a reduction in his take-home pay.
As the table shows, if Alec remains in the same tax bracket when he takes withdrawals as he was when he made the contribution, it shouldn't matter which type of 401(k) contribution he makes. If his tax rate goes up to 30% when he takes withdrawals, he would have an additional $3,502 on a withdrawal of Roth 401(k) contributions. On the other hand, if his tax rate drops by 5% (from 25% to 20%), he would have $3,501 more on a withdrawal of regular 401(k) contributions.
How to decide
As you can see from the above example, your current income tax rate vs. your expected future income tax rate is usually the most important factor in determining which type of contribution to make. In general, we suggest that you consider the following rules of thumb:
A few things to consider when thinking about how your current tax rate may compare to your rate when you take withdrawals:
No Roth choice at work?
Many employers only offer regular pretax 401(k) or 403(b) contributions. One way to still take advantage of a Roth account is to convert eligible assets in a workplace savings plan or traditional IRAs to a Roth IRA. A conversion will result in a tax liability the year you convert, but assets within the Roth IRA have the potential to grow income tax free.
Before doing a Roth conversion, you'll want to make sure you'll be able to pay income taxes on what you convert. It's typically better to pay them with money from a bank or other taxable account. If you use assets from a traditional tax-deferred account or IRA to pay the resulting tax liability, and you're under age 59½, you'll generally have to pay both regular income taxes and a 10% penalty on the amount withdrawn to pay the tax. This will significantly impact any potential benefit from conversion.
Also, if your plan offers matching contributions, consider contributing at least the amount necessary to receive the maximum employer match before you do anything else—it's like getting "free" money.
For more on Roth conversions, read Would You Benefit From a Roth IRA Conversion in 2010?
Another option to consider if your employer doesn't offer Roth contributions is to contribute to a Roth IRA. If you don't qualify for a Roth IRA because of your income, you can contribute to a traditional IRA and then convert it to a Roth IRA.3
Contributions to Roth IRAs are made with after-tax dollars, but the earnings are income tax-free once the five-year aging requirement has been met and the owner is age 59½ or older, disabled, or deceased.
Roth 401(k) or 403(b) contribution vs. Roth conversion?
We get this question a lot from our customers. You've decided that Roth-type savings are right for you. You have the choice of making Roth contributions to your 401(k) or 403(b) or converting traditional 401(k) or IRA balances to a Roth IRA. Is one choice better than the other? We suggest that if your employer matches contributions to a 401(k) or 403(b), contribute up to that amount first. Then, you will need to analyze whether it makes more sense over the long run to use your additional savings to pay taxes on a Roth conversion or to make a Roth contribution.
Dollar for dollar, if you are trying to increase the percentage of your Roth assets as quickly as possible, you'll be able to convert more pre-tax assets to a Roth compared to making a Roth 401(k) or 403(b) contribution. For example, if you have $5,000 after-tax, you could either contribute it to a Roth 401(k) or 403(b) or use it to pay the taxes on converting $20,000 of pretax assets from a traditional workplace plan or IRA to a Roth IRA (assuming you are in the 25% tax bracket).
Remember, however, that you need to consider a number of important factors before you convert, such as whether you believe it is a particularly advantageous year to convert if say you're in a low tax bracket or your investments have dropped in value due to stock market declines. The lower your current tax bracket, the more assets you'll be able to convert. The lower the market value of the assets eligible for conversion, the lower the tax liability for converting them. Another consideration: will you be eligible to make future Roth contributions? And finally, since a Roth conversion usually increases your taxable income it could impact your eligibility for tax benefits that are phased out at certain income limits or push you into a higher tax bracket.
Having choices when saving and investing for retirement is a good thing. But that also means that you need to make informed decisions. Because everyone's financial picture is different, we suggest that you take the time to carefully review your situation and work with a tax or financial advisor.
1. A distribution from a Roth IRA or earnings on Roth contributions to a 401(k) are federally tax free and penalty free provided the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, suffer a disability, or die. In addition, after the 5-year aging requirement is met, up to $10,000 is allowed to be withdrawn income tax-free for a qualified first-time home purchase.
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