There are some exceptions to this rule. For example, a Roth 401k may be the right choice if you make more than $1 million a year or if you make so little that you pay no income tax or very little income tax. But for the majority of us, the Roth 401k is better left alone. Here’s why.
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Roth 401k Basics
A Roth 401k is a retirement plan set up by employers that allow employees to contribute to their retirement. Unlike a traditional 401k that is tax deferred, however, money invested in a 401k Roth account is included in an employee’s taxable income. For example, if an employee is in the 25% federal tax bracket and pays 5% in state income tax, he or she would have to make $14,285 in gross income to invest $10,000 in a Roth 401k.
Here’s the math: $14,285 x 30% = $4,285 in taxes. $14,285 – $4,285 = $10,000.
The benefit of a Roth 401k is that your investments grow tax free. If by retirement that $10,000 has grown into $50,000, you pay no tax on the $40,000 gain. With a traditional 401k, the initial investment is excluded from your taxable income, but you do pay taxes on your entire 401k balance as you make withdraws from the account.
Why contributing to a Roth 401k is probably a mistake
Determining whether a Roth 401k or traditional 401k is best requires a bit of guess work. Traditional analysis asks whether your tax rate will be different when you contribute to the Roth 401k than it will when you make withdrawals from the retirement account. If your tax rate will be the same, the argument goes, than it makes no difference whether you invest in a traditional or Roth 401k. A tax rate that is higher when you make contributions than when you take withdrawals favors a traditional 401k, while a tax rate that is lower favors a Roth.
The problem with this analysis, however, is that it glosses over the difference between the marginal tax rate and the effective tax rate. The federal tax rate is progressive, meaning that the tax rate increases as your income increases. For example, here are the 2008 federal tax brackets as released by the IRS:
2008 Tax Brackets
|Tax Rate||Single||Married Filing Jointly|
|10%||Not over $8,025||Not over $16,050|
|15%||$8,025 – $32,550||$16,050 – $65,100|
|25%||$32,550 – $78,850||$65,100 – $131,450|
|28%||$78,850 – $164,550||$131,450 – $200,300|
|33%||$164,550 – $357,700||$200,300 – $357,700|
|35%||Over $357,700||Over $357,700|
As you can see, the tax rate increases as an individual or couple’s income increases.
Now the marginal tax rate is the highest rate that an individual or couple pays based on their income level. For those with taxable income over $357,700, their marginal rate is 35%. In contrast, the effective rate is the average income tax rate paid. Somebody with taxable income of $357,701, for example, only pays 35% income tax on the $1. An individual would pay 33% for taxable income over $164,550, 28% for the portion of their taxable income over $78,859, and so on. In the end, their effective tax rate would be the total tax paid divided by gross income, which would come out to a lot less than their marginal rate of 35%.
The key point for our purposes is that contributions to a traditional 401k reduce an individual’s tax liability at their marginal rate, not their effective rate. In contrast, withdrawals from a traditional 401k will be taxed, along with other retirement income, at your effective rate. So unless you expect your current marginal tax rate to equal or exceed your effective tax rate at retirement, the Roth 401k is not the best choice.
If you’d like to read a detailed analysis of the Roth 401k, check out Thinking About a Roth 401(k)? Think Again
Is a Roth 401k the right choice for anybody?
Sure. For those making in excess of $1 million, their effective tax rate and marginal tax rates begin to converge. Furthermore, they are likely to amass sufficient wealth such that their retirement income could exceed their current income, which could favor a Roth 401k. Also, if you live in a state that doesn’t have an income tax, but expect to move to a state that does during retirement, the Roth 401k may be the better choice. And a teenager who doesn’t earn enough to pay taxes but wants to save for retirement would be better off choosing a Roth account.
So choosing the right investment vehicle is not a one-size-fits-all proposition. And it should be noted that you can invest in both a Roth and traditional 401k. But for most, sound retirement planning suggests that we pass on the Roth 401k.
Here are some other Roth 401k articles worth reading: