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 For regular 401(k) or 403(b) contributions, both the contributions and any earnings on them are subject to taxes when withdrawn.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:

  • You typically have to begin taking minimum required distributions (MRDs) from your workplace savings plan for both types of contributions by April 1 of the year after you turn age 70½. Roth contributions and any earnings from them can generally be rolled to a Roth IRA, which typically doesn't require MRDs during your lifetime.
  • The combined limit for 2010 Roth and regular 401(k) and 403(b)  plan contributions is $16,500 in total if you're under age 50 and $22,000 if you're age 50 or older by 12/31/2010. (Review or change your contribution rate.)
  • Any matching contributions from your employer are made pretax (regardless of whether your contributions are Roth or regular pretax) and, as a result are subject to taxes when withdrawn.
  • You can make both types of contributions up to the combined limit.

An example

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.

regular vs roth contributions 

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:

  • Make regular pretax 401(k) or 403(b) contributions if you believe your combined federal, state, and local marginal income tax rate will be lower when you take withdrawals. With this strategy, known as tax deferral, you'll pay the taxes on your contributions and any earnings when you withdraw them. Also, because your contributions will reduce your current taxable income, you may be eligible for some tax benefits that are based on your adjusted gross income. In addition, if you expect to be able to claim itemized deductions during the withdrawal period, you will need taxable income to claim them against.
  • Make after-tax Roth 401(k) or 403(b) contributions if you believe your combined marginal tax rate will be higher when you take withdrawals. With this strategy, known as tax acceleration, your contributions are included in your current taxable income, but any earnings will be income tax-free provided you meet the requirements mentioned earlier.
  • Make a combination of both Roth and regular 401(k) or 403(b) contributions if you believe your combined marginal tax rate will be about the same in retirement, or if you are uncertain. This tax diversification strategy can help you manage taxes on your withdrawals because you should be able to withdraw a combination of tax-free and taxable assets.

A few things to consider when thinking about how your current tax rate may compare to your rate when you take withdrawals:

  • If you're under age 30, it's likely that your income and spending, even during retirement, will be higher than what it is now, at the beginning of your career.
  • Do you want to reduce your current taxable income?
  • Is your current income lower than usual or do you expect your future income to increase considerably?
  • Will you have pension/annuity income or income from taxable investments in retirement?
  • Do you want tax flexibility in retirement withdrawals?
  • Is most of your retirement savings in traditional 401(k) or 403(b) plans or IRAs?

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.

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.

Next steps

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. 

2. Other retirement savings vehicles that allow pretax contributions are 403(b) plans, 457 plans, and Keoghs, as well as traditional, SEP, and SIMPLE IRAs. Some 403(b) plans allow Roth contributions. 

3. To be eligible to make a full Roth IRA contribution for 2010, your adjusted gross income must be $105,000 or under if single or $167,000 or under if married, filing jointly. 

The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation. 

Investment and workplace savings plan products and services offered directly to investors and plan sponsors are provided by Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917.

Investment and workplace savings plan products and services distributed through investment professionals provided by Fidelity Investments Institutional Services Company, Inc., 100 Salem Street, Smithfield, RI 02917.

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